Ray's insights on these 2 choices - Posted by Mike S

Posted by Mike S. on May 31, 2009 at 15:53:44:

When you sell, you have 45 days from the closing date to identify up to 3 properties. You then have 180 days from the closing date to close on one of those 3 choices. In my case I would pay capital gains on the gain as well as the depreciation recapture dating back to a previous property I owned prior to the one I just sold. (because I did a 1031 exchange at that time) If I buy one of the 3 that I identified…No capital gains.

I have no experience with flips so perhaps another can answer your question better, but I understand flips are taxed as ordinary income due to the short term hold. (flippers please correct me) I’m not sure if there is a way to shelter the income, but with the long term holds that I do, you have to move into a “like kind” property. No stocks, bonds etc.

Thats all I have.

Mike S.

P.S. Thanks again to Ray for answering my questions in detail. It’s good to get input from a pro.

Ray’s insights on these 2 choices - Posted by Mike S

Posted by Mike S on May 19, 2009 at 20:54:37:

I have 800G in a 1031 escrow account. Looking at 2 deals, one is a absolute NNN auto repair building with a regional company. The other is a partnership with a reputable developer rezoning and developing an obsolete building into a multi use/Independent living facility in a retirement community.

The auto repair buisness has a 10 year corporate guarantee and comes in at a 8.5 cap, however the financials don’t look very strong to me. They have been in business for 30 years and have over 30 locations that they franchise out.(they dont actually operate any of their locations) I haven’t seen any of their franchisee’s go dark that I know of.

On the other deal the developer will give me a percentage owenership (12.5%)based on our equity positions and will pay me 4% on my money while remodeling/building/leasing the warehouse and ILF. Total cost will come in at 24 million financed by HUD. He figures 2 years before my return starts going up and 5-6 years to get things running on all cylinders. This developer has been very successful over the last 30 years, has experience in retirement type homes, has done mostly redevelopement/rezoning of obsolete properties and his financials are very strong.

I do own your course, however any thoughts on these specific deals would be greatly appreciated. Good to see you back Ray.
Thank you,
Mike

Re: Ray’s insights on these 2 choices - Posted by david

Posted by david on May 26, 2009 at 19:11:35:

in todays environment on nnn deals with questionable credit you should get 9% cap rate

Re: Ray’s insights on these 2 choices - Posted by ray@lcorn

Posted by ray@lcorn on May 25, 2009 at 08:18:21:

Hi Mike,

My answer would depend on your current investment objective. For most of us $800T is a significant amount of money, but for some it may be a small portion of investable funds. Which it is for you is a factor in the decision, as is where you are in life, e.g. age, dependents, other income sources, etc.

The developer deal assumes a long time horizon, no management responsibilities, nominal investment return with an equity kicker that doubles as the risk premium. The downside is that your funds are committed for the long term, you have no control, and at risk of gov’t funding snafus (which in an environment of trillion-dollar deficits cannot be discounted lightly). In my view this is a suitable investment for someone with a long time horizon (that is, age 50 or younger) and the amount represents no more than 20%-25% of investable assets.

The NNN deal offers 100% control, a decent return (though based on your comment of weak financials the cap is probably about 100 bps too low), and some measure of liquidity in that there is an active market for NNN single-tenant deals. The downside is that there is likely no upside other than any rent increases built into the lease, and the specialty nature of the building, and from your comment about the financials it probably isn’t an investment grade tenant. That dictates the finance terms available, hence the amount of tax-free funds available for other investments.

Before saying “no”, I’d want to know more about the “dirt-value” (e.g. location attributes, demographics, sales price PSF vs. replacement cost, etc.), length of time remaining on the lease and renewal options. It could be that the residual value offsets the tenant risk.

The main attraction of a true NNN credit tenant lease (CTL) deal is the dual exit strategy for the capital. With 1031 equity funds it is common practice to do a cash-out refi subsequent to acquisition. The better the tenant credit, the better the finance terms available, and the more funds that can be accessed tax free. Assuming adequate tenant quality and reasonable dirt-value factors they can be suitable for almost any investor.

ray

p.s. for more on the “dirt-value” factors mentioned above, see the article “The Risks & Benefits of Triple-Net (NNN) Properties” at http://www.creonline.com/articles/art-286.html

Re: Ray’s insights on these 2 choices - Posted by Mike S.

Posted by Mike S. on May 25, 2009 at 09:34:56:

Thanks for your response Ray,
The NNN deal is brand new, they get their C.O. this week, so this is a full 10 year lease with 2 five year options. The lease is with oorporate. (the franshisor) The Franshisee pays corporate each month and then corporate pays me. The weak financials are with corporate, which being just a franchisor and not a operator, makes me unsure how strong they need to be. The demographics and traffic counts of the area are very strong. (I can’t think of an area in Salt Lake City that would be any stronger) The Purchase price is 1,620,000 of which 412,000 is land value. The building is 3750 sq ft, so about $325 psf. Nice building, rock facade etc, however I’m not sure what replacement costs would be. (guessing $150 psf)

The 800K represents the majority of my investing capital. I’m 50 but am still looking more for growth as I don’t depend on my investment income to support my family. If I do the developement deal we’ve agreed that I’d come in for only 500K and I’d take the capital gains hit on the other 300K.

With the developement deal we’d subdivide off 6 acres of the 17 acres which I’d have title to. In 2 years I could then trade into the partnership or have my 500K returned to me if I’m unhappy about how the project has progressed. This facilitates my 1031 as well as offers me some security and a small return . The land in St George Ut has been rezoned to build up to 4 stories high so the value of the 6 acres would be secure.

Thanks again Ray for looking at these 2 options.

Mike

P.S. My accountant has told me to be cautious about purchasing a property and then immediatly refinancing as the IRS would consider this a taxable event if audited.

Re: Ray’s insights on these 2 choices - Posted by Chris

Posted by Chris on June 10, 2009 at 15:08:20:

Mike,

I live in Salt Lake and, honestly, you don’t want to do either of these
projects. Land in St. George is only in marginally better shape than
land in Vegas right now; Salt Lake is a great place to invest, but there
are much better deals than the one you’ve listed. $325 psf is more
than double what you should be paying, even in the heart of
downtown. Feel free to shoot me a line.

Chris Parker
8014270844
sentient.re@gmail.com

Re: Ray’s insights on these 2 choices - Posted by ray@lcorn

Posted by ray@lcorn on May 27, 2009 at 06:04:03:

Mike,

I’m tempted to laud you for volunteering to pay your “fair share” of our trillion-dollar deficit by taking the tax hit on $300T, but my mercenary heart just won’t allow it. :wink:

Don’t forget that the tax won’t be just the 15% cap gains rate. There will be depreciation recapture at 25%, plus any state tax that’s applicable. Add it all up and then calculate how long it will take and at what return on the remaining principal to replace it. That might change your mind. If the total taxes are a conservative $55,000 you’ve lost 18% of earning power. In a world of average investment returns of 6% or less, that will take 12 years to replace. (Use the 4% you’re settling for on the $500T and it takes 18 years.)

That leads me to the next comment. I don’t like the development deal at all now that the details are known. You’re making a loan that no bank or hard money lender would touch. Land values are a lot like restaurant equipment… they look great on paper, but lose a lot when the auction hammer comes down. As a land-banking, hard money lender friend of mine is fond of saying, his rule of thumb is to take the current market value of the land, cut it in half, then lend half of that. And by the way, he gets six points to do the deal. You are acting as the developer’s banker on very soft terms. Figure in the taxes you are paying as a cost of doing the deal and rather than earning a return, you’re actually paying dearly for the privilege of putting your capital at risk.

The NNN deal I also don’t like. This sounds like a quickie oil-change station? Whatever, the purchase price is three times replacement cost (i.e. $432 PSF); the rent is top-of-market ($36.72 PSF), it’s a specialty building, and the tenant has weak financials. The residual value is maybe 50% of the price. There is no upside and no exit strategy. It will decline in value as each year of the lease ticks by. Deals like this are trading at about 9.5%-10% caps right now, and I think that’s still too much.

However, it does have the advantage of producing income, no tax hit, and there is an exit strategy for about half your capital. Acquire it at a 10% cap rate, use a 45% LTC loan (assuming that meets the debt requirements of your 1031). Then refi with a 75% LTV, 5.5%, 20-year am, pulling out about $400T, which leaves a 15% or so return on the remaining equity.

On the refi pre- or post-1031 issue, it is my understanding that the danger is in the former, not the latter. I would refer you to an acknowledged expert on the subject, Bill Exeter at www.exeterco.com. His online manual states:

Refinancing and Exchanges
A common concern among investors conducting a tax-deferred like-kind exchange is the ability to withdraw equity from the investment property without incurring any income tax liability. Since cash or debt relief constitutes taxable boot, the concern is that pulling cash equity out of a property before, during or after a tax-deferred like-kind exchange transaction would result in the disallowance of the tax-deferred like-kind exchange transaction and full tax liability for the Investor.

It is possible for the Internal Revenue Service to take the position that the refinance transaction has been structured specifically to evade payment of income taxes, collapse the exchange as a â??stepâ?? transaction, and complete disallow the tax-deferred like-kind exchange transaction. The preamble to the Department of the Treasury Regulations contains language stating that refinancing immediately prior to a tax-deferred like-kind exchange transaction will result in the disallowance of the tax-deferred like-kind exchange, so the Investor is best advised to refinance at least six months prior to execution of an exchange, or waiting until the completion of the exchange to refinance.

(Section 1031 Tax-Deferred Exchange Reference Manual; Page No. 59; © Copyright 2001-2006 by William L. Exeter. All Rights Reserved. www.exeterco.com; 866-393-8377)

The direct link to the Exetor Co. manual is
http://www.exeterco.com/pdfs/Section_1031_Tax_Deferred_Exchange_Reference_Manual.pdf

So my advice is to keep looking. This is the best buyer’s market we’ve had in years and you can get beter deals than either of these. I think given your described circumstances the NNN CTL (credit tenant lease) deals are going to be most suitable.

Best of dealmaking,

ray

Re: Ray’s insights on these 2 choices - Posted by Mike S.

Posted by Mike S. on May 27, 2009 at 08:56:03:

The NNN deal is actually a 2 bay auto repair shop with another 2 bays for lube, but that being said, you’re right. The residual value isn’t there.

I blew it Ray, as my 45 days are past. I did identify a 3rd choice which is a Tony Thompson TIC deal. It’s that or capital gains on the entire 800K. OUCH!

Thanks again Ray for setting me straight.

Re: Ray’s insights on these 2 choices - Posted by ray@lcorn

Posted by ray@lcorn on May 27, 2009 at 11:12:20:

Mike,

I don’t know anything about Tony Thompson, but I know a lot about TIC deals. (Do a search on DBSI Inc., using all caps) I’d rank that as a (very) distant third choice regardless of the details.

Given the ID period has passed, the NNN deal is the better bet than paying the taxes and/or doing the land deal. There is a lease, with income, and access to at least half the equity.

Not a home run, but a wealth builder if the tenant survives all 10 years, and you put the $400T in the right place. But whatever you decide, PLEASE don’t pay the taxes! :wink:

ray

Re: Oops - Posted by Mike S.

Posted by Mike S. on May 27, 2009 at 11:06:55:

When I posted the NNN sq footage, I based that on what the lease stated. (signed prior to construction) I just looked at the architect drawings and it is going to be 7591 total sq ft if you count the basement bay areas and 5874 if you only count above ground areas. $213 psf or $276 psf to build and lease rates of $17.91 psf or $23.15 psf. Sounds a little better though the residuals still stink. But…at least I’d avoid funding wasteful goverment programs.

I’ll have to read your book about 5 times before I do another deal (once is not enough) as it is full of useful information. Once again I appreciate the lengthy replys to my posts and sorry about the inaccurate numbers I provided. Mike

Re: One more thought - Posted by ray@lcorn

Posted by ray@lcorn on May 27, 2009 at 11:20:22:

Mike,

That makes it a little better… a lot actually because the basement and the extra square footage grant some alternative use possibilities, hence improving residual value.

One more thought on the post-closing cash-out refi issue. If you want to avoid any chance of having the exchange denied, wait until the next tax year to do the refi. Even the most conservative accountant will tell you that’s as close to bulletproof as you can get.

Given the state of the capital markets right now you might also get better terms by waiting. Use bank financing to close, then shop around for a term loan in January. I do believe CMBS will be back in the second half of the year, but under very conservative underwriting standards.

ray

Re: One more thought - Posted by Mike

Posted by Mike on May 31, 2009 at 05:50:31:

Im confused! If you invest all of the $800,000 back into real estate before Dec 31 of this year then wont you avoid paying any taxes on it?

Or will you be taxed on all the recapturing of the depreciation you took over the years of owning the property.

For instance my accountant told me that if I make $50,000 profit from a flip and reinvest that money before Dec 31 of that year, back into real estate, stocks, bonds, bank cds, etc then I would not have to pay any captial gains tax on that money?

Is this not the case?

Re: One more thought - Posted by ray@lcorn

Posted by ray@lcorn on June 02, 2009 at 10:24:24:

Mike,

You’re so confused I don’t know where to start…

First, a flip (generally defined as a property held less than one year with the intent to resell, i.e. not held for investment) does not qualify for a 1031 tax-deferred exchange, which is what we were tallking about above.

Second, your accountant should lose his license if the advice he gave you was for a true flip, and doubly so if it is in fact investment property. A 1031 exchange must involve “like-kind property” (see article referred to below). “Stocks, bonds, bank cds” etc. do not qualify as like kind and would not be elegible even if the deal were not a flip.

Last, the depreciation recapture tax applies only to the sale of long-term assets qualified as capital gains if a 1031 is not elected. A flip is cannot be depreciated as it is considered dealer inventory, therefore recapture does not apply.

For 1031 basics, see my article at http://www.creonline.com/articles/art-159.html

ray

p.s. and get a new accountant