Tuesday, May 25

This Blog Has Moved to a New Location


The Inside 1031 blog previously hosted at this domain has been moved to the following location:

www.inside1031.com

All previous blogs entries are hosted there and please continue to visit for all the latest 1031 exchange information and analysis.Sphere: Related Content

Wednesday, May 12

How Net Lease Zeros Add Up to Big Tax Savings


Simply speaking a zero transaction is the acquisition of a property using a highly leveraged loan (loan to value usually 88% plus) with all rental income dedicated towards debt service, thus producing “zero income” for the property owner. One of the vehicle’s applications is to defer tax liabilities incurred in a commercial foreclosure.

The Problem

Though it is not widely known, the foreclosure of a commercial property is often a taxable event. How the IRS computes the tax depends on whether the property was financed with a recourse or non-recourse loan. In the case of a recourse loan, tax liability is calculated by taking the difference between a property’s fair market value and its adjusted basis. The tax liability of a non-recourse loan (which the remainder of this piece will be dealing with) is calculated by taking the difference between a property’s outstanding mortgage balance and the property’s adjusted tax basis.

The key element which catches investors off guard is that “outstanding mortgage balance” includes any loan taken out during a refinancing of the property.

For example:

Let’s say you bought a property for $5M (your cost basis) which subsequently has been depreciated to an adjusted tax basis of $3M. Let’s also say you refinanced this property during an upsurge in the market and pulled out $8M of equity. If this transaction was foreclosed upon (without any action to defer tax liabilities), you would face a taxable gain of $5M, i.e. the $8M in outstanding mortgage amount minus the $3M in adjusted tax basis.

Thus, investors who think returning the keys to the bank absolves them of all monetary concern involved in a commercial foreclosure are gravely mistaken. The IRS views any money pulled from a property via loan refinancing to be taxable gain, even though the property is foreclosed upon.

The Solution

With proper scheduling and use of the 1031 exchange, the situation above can be avoided through the purchase of a “zero income” property. The reason a zero income property can be so beneficial is due to its highly leveraged nature and its ability to defer a taxable gain through a 1031 transaction. A portion of the money an investor would have otherwise paid to the IRS can be used instead to acquire the zero income property through the 1031 exchange.

For this transaction to work a few things usually need to be in place:

• Due to the rules of the 1031 exchange, the replacement “zero income” property has to be of equal or more value than the original property. In this case the value the client needs to trade equal or up to is the value of the outstanding mortgage being forgiven.

• Furthermore all 1031 exchange procedures must be followed including preparing exchange agreements, identifying replacement property and closing within 180 days.

• The investor must carefully select the zero income replacement property. The primary characteristics will be a triple net lease (NNN) and an investment grade tenant (usually rated by independent agencies such as S&P or Moody’s). These properties are considered extremely stable real estate investments and are normally the only ones capable of being financed with the highly leveraged loan needed in a zero transaction.

• A “deed in lieu of foreclosure” must be obtained to allow for the appropriate transfer of the original property to the bank. Creditors generally prefer a deed in lieu of foreclosure because it terminates the debtor’s equity of redemption and is quicker, less expensive and less unwieldy than a traditional foreclosure.

In order for the transaction to flow smoothly, it will have to be properly organized and scheduled on an individual basis. It should be noted that a zero transaction is not possible without outside assistance of at least a Qualified Intermediary and qualified professional tax and accounting advice. If done properly, this strategy can be an invaluable tool for investors caught in a foreclosure situation.

Here is how our previous example would be impacted by a zero transaction:

Assuming a tax rate of 25% (Federal capital gains rates, Federal recapture rates and states taxes), the $5M in gain would cost $1.25M in taxes. If instead, a zero transaction was pursued, the investor would need to replace the balance of the debt, $8M. By exchanging into a zero income property for approximately 10% of the $8M debt amount replaced ($800,000), there would be a $450,000 savings ($1.25M-$800,000) and the investor would own NNN property with a very high credit tenant.Sphere: Related Content
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