Sell it or lease it? - Posted by General Lee Confused

Posted by ray@lcorn on July 24, 2007 at 15:34:34:

Hi Frank,

As a technical point, the simultaneous exchange is what was originally provided for in IRC Sec. 1031 dealing with like-kind exchanges. A later tax court ruling, known as the “Starker” case, led to the adoption of protocols in 1984 for the delayed exchange so popular today. (For a more detailed history of 1031 and like-kind exchanges, see Bill Exeter’s article at http://www.exeterco.com/History_Section_1031.aspx)

As a point of correction, the time periods for the delayed exchange are 180 days to close the replacement property, inclusive of the 45 day ID period to identify the replacement property. Both time periods run simultaneously, meaning the clock starts on the date of closing of the relinquished property. The total time permitted from start to finish is 180 days, with no exceptions.

The hold period is a separate issue from the procedural requirements, and addresses qualifying property. The code says “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

So the test for qualifying property revolves around the interpretation of “held for productive use in a trade or business or for investment…”. Since no minimum hold period is specified as a litmus test for “held…”, the question has historically come down to what constitutes an intent to hold for investment. In the end it is either a qualifying property or it isn’t, and if the latter the exchange would be disallowed in either a simultaneous or delayed exchange because of its non-qualified status. (see also, http://www.exeterco.com/holding_guidelines_for_1031_exchange_property.aspx)

That said, your point is valid and one I didn’t think about. The simultaneous exchange would offer another alternative in working with a buyer, though at the cost of directly involving the buyer in your choice of replacement, and possibly creating conflicts with the seller of the replacement property.

ray

Sell it or lease it? - Posted by General Lee Confused

Posted by General Lee Confused on July 19, 2007 at 18:47:44:

Hi,
I recently bought a downtown row building at a good discount. My intent was to either put my retail business there or lease it to a business owner.

Shortly after I bought it (like one week), a person asked to lease it–I hadn’t even advertised it, but I guess that’s a small town for ya.

Anyway, the prospective lessee also offered to buy the building from me at just under triple what I paid for it.

Will you please give me arguements for a)leasing the property for long-term profits and b)selling it for instant profits.

All opinions welcome.

Thank you.

Tom

Thanks mucho! - Posted by General Lee Thankful

Posted by General Lee Thankful on July 29, 2007 at 13:59:24:

Thanks everyone for your thorough and thoughtful answers.

In more recent conversations, the prospective tenant (who is also the prospective buyer in this case) told me that if I wouldn’t sell the building to him, a 10-year lease is preferred. Otherwise, he’d like to buy the building.

Then, I got another update–he’s developed some health concern in the last week and went to the hospital Friday to see if it’s anything serious or just caused by temporary stress.

So now it seems both ideas are in limbo for now. :frowning:

But I think I will sell it rather than lease it if that opportunity works out.

Thanks again. I really appreciate the thoroughness of the answers here!

Tom

Lease or sell–more details here - Posted by General Lee Confused

Posted by General Lee Confused on July 21, 2007 at 16:36:30:

Thanks. This is in a very small town with depressed economy. For the past 15-20 years the economic and population base has been shrinking. 2006 was the first year in that long that the town didn’t have negative growth, so that may be a good sign. The average age has been increasing as the young people move to the cities for jobs (and, admittedly, fun).

I bought the building for about 14 percent of the county tax appraisal. The tax appraisals in this town are very tight with FMV.

There was a financial encumberance which equalled about 22% of the tax appraisal. I knew about this up front.

The owner wished to sell because he’d been abused by his tenant The tenant left the property in very poor condition and with the encumberance mentioned above. The landlord is an older man, and was just so hurt emotionally by this tenant abusing him (Landlord had assisted the tenant in starting a business) that he just wanted to get out. He cleaned up the building about 60% then just gave up and put it up for sale below market value.

When I came to tour the building, he told me the story and then said you can pay me whatever you want to–I just want rid of it! In fact, he said, I’ll give you the building for free if you’ll just pay the encumberance.

Well, I really love a bargain and maybe this makes me a bad investor, but I didn’t want to take the building from the man for nothing, so I offered what I ended up paying.

So altogether I’ve invested 36-37% of tax appraisal amount in the building including paying the encumberance.

I’d intended to put my own business there or lease it out, but then the person who wanted to lease it asked if I wished to sell it.

That person offered me slightly over tax appraisal amount, so the offer is realistically probably still FMV.

After purchase cost, paying encumberance, and estimated sales expenses, I should have almost tripled my money.

On the other hand, the same person would consider leasing from me for $400-500/mo on a 10-year lease (plus annual increases to match taxes).

As you can see, over 10 years the income could be nice. However, it is a small, depressed town (which showed its first population non-loss year in 15 years in 2006–so maybe it’s turning around).

I just don’t know whether it’s wisest to wait for the long-term returns, or get cash for that bird-in-hand.

Thanks again

Re: Sell it or lease it? - Posted by Penny

Posted by Penny on July 21, 2007 at 13:23:40:

Here are some general thoughts in no particular order.

You didn’t post numbers, so I’m guessing they look something along these lines: example property value 100k (vacant market value), your price 70k (30% discount), offer 200k (2x market value). So 200k/70k is almost 3. Or some set of numbers with similar ratios.

Do you have numbers on the leased up value compared to the offer?

If you sell, you have selling costs and your profit is taxed at ordinary income rates not capital gains because of the short holding time.

You could defer the taxes by using a 1031 tax exchange where you buy something bigger within a strict timeframe under IRS rules, however.

You say you are in a small town - sometimes properties do not move as quickly in these areas unless the discounts are significant. Is the market growing or declining?

You bought below market value. How long was it on the market before you bought it and what enabled you to get it at the discount? What makes this prospective buyer think it is worth significantly above market value?

Strike while the iron is hot.

You could take the money, do a 1031 and invest it into something bigger that will give you bigger long-term cash flow.

If you keep and lease, you could still access some equity via refi or commercial HELOC.

Fundamental accounting: more money in sooner = good, less money in later = not so good

Hope this helps.

Re: Sell it or lease it? - Posted by brandoncbsre@lycos.com

Posted by brandoncbsre@lycos.com on July 21, 2007 at 11:27:11:

Without knowing any more it is hard to say, but a nearly 200 percent return in a short period sounds pretty good.

Re: Lease or sell–more details here - Posted by ray@lcorn

Posted by ray@lcorn on July 23, 2007 at 13:56:55:

General,

I’m glad you’re considering the question in the context of the market demographics. That’s the right way to evaluate long-term values. What caused the population increase in 2006? Did something happen that portends a turnaround, or was it a one-time blip? Since you mentioned the area has been economically depressed for 15-20 years and the average age is increasing, the latter would seem more likely.

If so, then the immediate sale makes more sense. You’re avoiding what’s known as residual value risk, which by nature is out of your control. Like Penny said below… sure money now beats maybe money later.

But your tax status may be a factor in the decision. An sale in less than a year will be taxable as ordinary income. Holding for one year or more will qualify for capital gains rate, currently 15% (plus depreciation recapture, but in this case that won’t be a factor).

Depending on the amounts involved (i.e. the amount of gain, your underlying tax bracket, and the AMT calculation) that can make a significant difference. If the amount is low enough to not kick you above the 20% or so bracket, or if you can shift your other income between tax years you may minimize the effects of the gain.

To qualify for 1031 treatment the taxpayer must purchase the property with the intent to “hold for investment”. The code does not have an specific minimum holding time that defines “intent”, so there is room for interpretation. It is commonly understood to mean a rental property must be held for at least one year, preferably spanning two tax years. Most accountants will tell you a 1031 with less than one year holding time would be shaky at best. I read of a case in which such a 1031 was upheld… what made the difference was the owner bought the property with the intent to hold, advertised the space for rent, signed a lease with a tenant, then sold the property adhering to the 1031 requirements. Consider that an anecdote, not advice or a legal opinion.

Another option would be an installment sale, however the holding time prior to sale becomes an issue there as well. Less than one year would be considered dealer property and installment sale treatment would not be available. Again I don’t know the amounts involved, and that would have a bearing on my decision.

That leaves a couple of other choices… a lease/option structure with an incentive for the tenant buyer to exercise at the end of one year, or a straight option sold separately from the lease.

All in all, this is the type of problem that’s nice to have. :wink:

ray

Re: Lease or sell–more details here - Posted by Penny

Posted by Penny on July 22, 2007 at 08:03:45:

Boy, my numbers were sure off!!

It looks like you did an exceptional job on the purchase, congratulations! You make your money on the buy, and did very well on this one.

As others have pointed out on this board: Know your market. Know your investment goals and risk tolerance.

I think you have some more homework to do to help you decide, but here’s some more thoughts. Run the numbers for the following scenarios.

You could - sell today for a known profit. Benefit - easy exit from a higher risk market. Risk - losing out on more potential profit by selling a vacant versus fully leased property.

You could - finish the clean up, lease it and then sell at an even higher profit. In this case, if you hold for a year, then you can take advantage of the long term capital gains rates instead of ordinary income rates for short term holdings. Risk - longer time on market for small town property. Benefit - more profit but over a longer time frame.

You could - keep it for cash flow, structure the lease in a triple net type format and index CAM & base rents for inflation. Risk - long term market stability could affect actual returns. Benefit - longer term monthly cash flow indexed for inflation.

The risks of holding long term all relate to the small town market. If it is declining, what is the risk that the tenant business will still be operating in 10 years? How long has the tenant been in business and is it a business that serves the demographics well? Or will you be stuck halfway through a lease with a defaulting tenant?

Hope this helps.

1031 vs Simultaneous Exchange - Posted by Frank Chin

Posted by Frank Chin on July 24, 2007 at 04:00:50:

Ray:

You said:

‘To qualify for 1031 treatment the taxpayer must purchase the property with the intent to “hold for investment”’.

I know an investor in the shoes of this investor arranged to have a simultaneous exchange done, to sidestep the “holding period” requirements of the 1031 deferred exchange.

As in this case, a buyer wanted the property, somewhat badly, as a user. So the seller had an agreement made with the buyer that would give the seller time to search for a replacement property. The agreement also calls for his buyer to then contract for the replacement property, and then at a simultaneouss closing, take possession of it, and then immediately exchange it for his property. Basically, a two way exchange.

I believe there are no holding periods required with such exchanges, basically, I take over your property, bascially exchanging deeds. But I beleive there’s probably more fancy footwork involved with getting mortgages approved and so forth.

The seller’s view is that for a motivated buyer, you can get the buyer to jump through more hoops as compared to deferred exchanges, where the buyer is not that much involved in the seller’s leg of the transaction.

Additionally, I beleive the 180 days to identify, and 270 days to close requirements are unique to 1031 exchanges, and does not apply to simultaneous exchanges.

Frank Chin