NestEgg Investing: 1031 Tenants in Common Exchanges

Researching a 1031 TIC Exchange Firm Part 4

Continued from Researching a 1031 Firm Part 4 (Link)

11) Confirm the 1031 syndicator's projections:  How are the projected incoming rents secured? Is it secured by a long term lease, or are you exposed to tenants moving out?  For non-"true triple net leases" (where syndicators are the master leasee), how realistic are the projections for maintenance upgrades and property improvements?

12) Validate the local real estate market:  For people investing in properties outside their local area, really research the targeted property's regional market.  Returns in real estate are from both cash flow and appreciation.   Try to understand the underlying dynamics--population growth, employment growth, wage growth, and historical appreciation rates.

13)  Validate the value of the property:  Be skeptical of the appraiser's valuations.  Look at local comparables.  The hard part in the industry is acquiring properties.  Syndicators looking to make a quick buck, overpay.

14)  Understand how TIC agreements affect things like property management, repairs.

1031-121 Exchange-Don't Rush to Sell When a Spouse Dies

Full Article: http://www.centredaily.com/mld/charlotte/living/home/11468875.htm?source=rss&channel=charlotte_home

ROBERT BRUSS

Q. My wife and I, now in our 80s, own our home worth around $800,000. After one of us passes on, how long does the survivor have to sell the house before losing half of the $500,000 principal-residence sale exemption?

After one principal residence co-owner dies, the survivor should not rush to sell the home.

Internal Revenue Code 121 says a surviving spouse has until the end of the year of the other spouse's death to sell the principal residence and claim up to $500,000 tax-free profits. The tax reason is the year of a spouse's death is the last year a surviving spouse can file a joint-income tax return with the deceased spouse.

However, IRC 121 doesn't mention the stepped-up basis benefit for a surviving spouse who inherits the deceased spouse's half of the principal residence.

Suppose you and your wife are both on the title to your home. You die. Your widow will receive a new stepped-up basis to market value for the half of the residence inherited from you.

In a community-property state, the entire value of the house will be stepped up to market value on the date of your death.

Please ask your tax adviser for full details.

Tax-deferred exchange

Q. I own a modest apartment building, which I can sell for a net profit of almost $1 million. I would like to make an Internal Revenue Code 1031 tax-deferred exchange for a nice retirement home for my wife and me plus a rental property. Can we do this in a tax-deferred exchange? Not immediately. All properties in an Internal Revenue Code 1031 tax-deferred exchange must be held for investment or use in a trade or business. That means the properties you acquire must be held for rental or use in your business.

You can make a direct tax-deferred trade for a "nice retirement home." To qualify, it must be a rental property at the time of acquisition and for at least six to 12 months thereafter.

Later, the tax law does not prevent you from converting one of those rental properties acquired into your retirement home. No tax will then be due upon conversion from rental to personal use. For full details, please consult your tax adviser.

How do you know a 1031 TIC Exchange Firm is Honest?

I got the following questions emailed to me:

are the main questions we should ask of the RSP or real estate provider?

how do we know they  are honest?

how do we know the property is really going to yield 6-7 %?

1) All the questions that I list on how to choose the right 1031 exchange firm (link) are questions you should ask the real estate firm, other investors and folks like your CPA, CFA.  For your CFA, ask if they have any biases, commissions,etc. Often the CFA is recieving a 5% commission to introduce you to a firm

2) How do you know they are honest?  This is a tough one.  Asking prior investors is the best way to tell.  Also, take a look at their fee structure.  If their fee structure is egregious (ie greater than 15% of equity rolled in) it's a sure sign that the firm is trying to make a quick buck.  You can also ask a a lawyer or friend who is a lawyer to take a quick look to see if the ceo of the organization or the organization itself has ever been sued

3) How do you know you will get the promised yield?  Most offerings have a triplenet lease which is a contract guaranteeing the return.  To make sure that the firm lives up to the guarantee, ask if there has ever been a capital call.  Also, look to see how aggressive the loan agreement is.  If it's a variable, interest only loan, you might ask how the firm is going to continue its cash yield commitments when interest rates rise and principal needs to paid back.

To better serve you, we're looking to launch a feedback project on 1031 service providers (find out more link) .  If you think this would be valuable, please post  comment or email us at nesteggemail@gmail.com

1990's-Present 1031 Exchange IRS Rulings

1990’s
-Revenue Ruling 1990-34 (Direct Deeding of Replacement Property)

2000
-Revenue Procedure 2000-37 (Parking Arrangements for reverse 1031 exchange and build-to-suit 1031 exchange structures)

2002
-Revenue Procedure 2002-22 (Tenant-In-Common Program)
-Revenue Procedure 2002-69 (Classification of entities: Husband and wife: Community property: Separate entity: Partnership: Disregarded entity)

2003
-Revenue Procedure 2003-39 (LKE Program 1031 Exchanges)

2004
-Revenue Procedure 2004-51 (Improvements on land previously owned by taxpayer, amends Revenue Procedure 2000-37)
-Revenue Ruling 2004-77 (Classification of organizations for Federal tax purposes)

2005
-Revenue Procedure 2005-14 (tax exclusion available for profit on the sale of a personal residence with the tax deferral available with a Section 1031 "like kind" exchange of a rental property)

Conceptual Constraints on 1031 TIC Exchanges

To Provide Tax-Deferred Products, 1031 Central Must Adhere to Some Basic Principals:

• Holding Period: Properties acquired with the intent to flip, by sale or exchange, or by contribution to capital, cannot be exchanged in a like kind exchange
  Solution: Neither the statute nor the IRS states a requirement regarding hold time, however attorneys suggest a year is a good rule of thumb. This comes into play when you are thinking about doing a 1031 exchange on your primary residence (link) or generally if you're thinking of moving in and out of exchange properties quickly.

• TIC vs. Securities: TICs are considered “securities” under federal securities law, but it is critical that TIC interests sold to 1031 buyers not be categorized as “other securities” or “evidences of … interest” under federal tax law. TIC must be fractional ownerships of real property and must enjoy both the benefits and risks of owning property. Thus, some of the 1031-721/ UpREIT exchanges (link) which allow investors to put their shares back to TIC syndicators/ REITs may not be in the spirit of this concept.
  
• TIC vs. Partnerships: TIC can not function as a partnership. Thus, syndicators must find ways around issues such as central management agreements, right of first refusal, etc.
  

1031 TIC Exchanges Legal Overview

The new 1031 options allow non-tax benefits such as geographic diversity, zero management, etc, but at its core, the 1031 exchange is a tax strategy.  Thus, it behooves a personal investor to try to understand the governing tax laws and as much as possible get comfortable with the future direction.  Thus, we've tried to provide some information here.  Neither of us are licensed lawyers, and you should not consider this legal counsel.  However, here's our (non-professional, not licensed understanding).  As with anything else on this website, consult a tax lawyer or CPA.

I've broken it up into sections:

1)  1031 Basics (Link)

2)  What you can and can't do (Link)

3) Conceptual constraints on 1031 transactions (Link)

4) Directions in 1031 rulings (Link) The evolution of 1031 rulings since the 1990s

5) Hints at the future in 1031 rulings (Link Coming Soon)

Researching a 1031 TIC Exchange Firm Part 3

Continued from previous post (link)

7) Has the firm ever been sued? 

8) Has the firm ever had to make a capital call?  If the firm has had to make a capital call, that means the firm used too much leverage, did not manage the property well enough, or made a similiar mistake.

9) How do I get out?  A life event may force you to have liquidate your ownership share earlier than you intended.  You should get in writing the process for selling down your ownership. In highly leverage buildings (70% debt), often the loan document must be amended and the new buyer approved by the bank.  This will incur significant fees in addition to the decrease in selling price do to your distressed situation.  Some firms won't let you get out at all.  More generally, have a firm layout in black and white exactly the restrictions (both legal and practical) you will face if you need to sell

10) Talk to prior investors: If you do anything at all, talk to private investors about their experience.  If you can find someone not referred by the 1031 firm, all the better.  It will give you confidence that the firm you are working with is legitimate. Please also help others in this regard. If you have performed a 1031 exchange of any kind (traditional, TIC, etc.) and have feedback--good, bad, or indifferent-- on any the firms that you've worked with, please email us with feedback: nesteggemail@gmail.com

Continued at Researching a 1031 Firm Part 4 (link)

Researching a 1031 TIC Exchange Firm Part 2

Continued from previous post (link)

4) Fee Structure:  Have a 1031 syndicator layout on paper their entire fee structure.  Many times they will list the fees as a percentage of assets rather than a percentage of equity.  For example, a large firm quoted us fees of 10% of the asset purchased which sounded reasonable.  However, when you consider that the building was being purchased with 50% debt, the fees equated to 20% of equity exchanged which is higher than the national capital gains tax.

5) Underwriting Leverage:  From what we've seen, 1031 syndicators underwrite their purchases from 0% debt all the way up to 80% debt.  Obviously, the lower the debt, the less risky.  We generally think that around 50% debt makes sense.  With higher debt levels, there's greater chance that firm will not be able to cover debt service and deliver their guaranteed return.  Even worse, they are not able to cover debts service and will make a capital call which requires you to put more money in.

Finally, the greater the debt, the more restrictions the banks will have on the investors.  Thus, they may have restrictive covenants that prevent you to sell down your portion, etc.

Also pay attention to how this debt is structured.  Many firms will use interest only debt in the early years.  They do this to increase their yield to investors at the cost of big principle payments and lower returns (and potentially capital calls) in the future.

6) Debt Available to You:  When you do a 1031 exchange you need to rollover both your equity and your debt.  Most firms will provide loans for you.  This is helpful, as raising debt on your own can be difficult for a fractional ownership of a building.  Be careful about how these loans are secured. Many firms will over non-recourse loans which are secured by ownership in the building itself rather than your personal assets.

Diligence List Continued (Link)

1031 TIC Exchange Firm Due Diligence List

The 1031 industry is in some ways brand new.  As a result, it's pretty difficult to determine which firm you can trust.  To help sort through the wheat from chaff, we've put together a "due diligence list" below to help you more rigorously research firms to work with.  As always, consult your tax and financial advisors.

To better serve you, we're looking to launch a feedback project on 1031 service providers (find out more link) .  If you think this would be valuable, please post  comment or email us at nesteggemail@gmail.com

1) Firm background: Find out how long your 1031 syndicator has been in business, how many transactions they have performed, and how credible the leadership of the firm looks.  Many firms have grown out or are subsidiaries of title or brokerage companies.  So be careful about differentiation between the track record of the 1031 company and the parent company.

2) Offering:  First take a look at what type of offering (Tenants in Common, Tenants in Common Triplenet Leases, UpREIT). Generally, we feel that the UPREIT still has not been approved by the IRS and is thus more risky.  Second, look at the properties themselves:  research the geography, the tenants, and the general quality of the assets.  Finally, how big is their property portfolio.  The bigger usually will indicate a larger and more established firm.  Also, when you go to exchange it's more likely that they will have a property available.

3) Promised Return:  Be careful about exactly what return the firm is promising.  Some firms advertise "cash on cash yields"  which are really returns to your equity.  Others advertise capitalization rates which are returns to equity and debt. 

Diligence List Continued (Link)

Choosing the Right 1031 TIC Syndicator or Exchange Firm

Six months into our research, we do think that the new options available under the loosened 1031 law can very powerful vehicles for personal investors.  We've talked about this in the prior posts, but these new 1031 options allow investors to diversify geographically, to eliminate management (through exchanging into triple net leases), to increase yields (particularly if you are exchanging away from the low cap rate geographies like the Bay Area), and to reduce principal and tenant risk (if you are exchanging into institutional properties). 

That's great in theory, but how does play out where the rubber hits the road?  We're beginning to research actual firms that provide 1031 exchange options and our advice is be careful and really do your homework.  This is a new industry, and while there are some reputable firms, we've certainly found plenty of fly-night operations. 

To help you do your homework, we've created (and will update as we continue to do our research) a diligence list of good questions to answer before working with a 1031 syndicator.  As always, consult your financial and tax advisor.

Firm Due Diligence Checklist Link

Please also help us with this effort.  We're looking to launch a feedback project (find out more link) on 1031 service providers.  If you think this would be valuable, please post  comment or email us at nesteggemail@gmail.com.