Cashing out is just one of many options to consider
Last week we took a look at a disposition scenario for a highly-appreciated owner/user building in Anaheim. Our example mirrors the favorable situation that thousands of business owners find themselves in after an outsized run-up in property values from 2011 to late 2022. Though values have slipped a bit since then, the numbers are still mind-boggling. Who could have imagined their building’s value quadrupling in 11 years? Certainly not us, as our decades of experience just wouldn’t allow it.
But here you are (if you are an owner/user), sitting on a mountain of equity, left to wonder what the heck you should do next. A good problem to have, but not an easy puzzle to solve, since the optimum course of action is influenced by so many variables unique to your circumstances.
Our example from last week modeled a straight sale, whereby the capital gain was realized and an uncomfortable amount of taxes were paid. Yet, our property owner still walked away with almost 30 times his original down payment, after taxes. If that is not an upper-deck home run, we don’t know what one looks like. Click here to view that post.
Here, we take a look at some of your other options, the most common of which is the 1031 exchange, whereby you sell your existing property and acquire another property or properties of equal or greater value that optimizes your ability to earn a strong stream of rental income and reduce your risk. If structured properly, all capital gains taxes are deferred, which is great for those who just don’t have the stomach for stroking huge checks to Uncle Sam and Gavin. The most common 1031 acquisition is a single-tenant-net-leased property (STNL), typically a space leased long-term to an institutional grade tenant like a McDonalds or a CVS store. In the STNL scenario, risk of lost rental income is very low and there is no management responsibility, making it a good option for those who plan to fund their retirement with rental income. However, the returns are lower to reflect the low risk profile. Also, good STNL properties are difficult to find in prime markets like Orange County, so these opportunities are often found in secondary markets that the exchanger may know little about.
Exchanging into other asset classes like local office buildings, shopping centers or multi-family properties is another option. But, they carry more leasing risk and are more management intensive. For those willing to tolerate some leasing risk, but want to stay with something closer to home, holding their existing industrial property to lease to another industrial business is also a viable option. The sense of safety associated with sticking with something they know tends to mitigate the ongoing risk of ownership, at least psychologically. Also, since no sale is taking place, there is no taxable event, another plus for the tax averse owner.
Another element of risk, especially for those at or nearing retirement age, is debt. Debt magnifies the impact of vacancy, as the owner not only loses rental income, but has to come out of pocket for mortgage payments during the re-leasing period. Depending on market conditions when a building becomes vacant, these losses can be substantial.
If debt figures into the equation, the owner/user has yet another option. To fully defer paying taxes on a capital gain, the exchanger must invest all of his equity in the up-leg property, and either replace the debt that’s being paid off in the sale of the down-leg property, or add an equal amount of cash from outside the transaction, which most people choose not to do. However, the investor may choose to forego taking on the required debt to acquire the up-leg and pay capital gains on the amount of mortgage relief he receives, also known as mortgage boot. In this instance, most of the tax is deferred and the risk of debt is eliminated.
The important point here is that structuring an exchange is not an all-or-nothing decision. Depending on individual circumstances, paying some tax makes perfect sense, especially for those looking to reduce risk.
Next week we’ll discuss some other creative exchange ideas to access equity, improve quality of life and stay a step ahead of the tax man at the same time. Stay tuned.