Equity Based Services, Inc

by Troy Downing

One thing (among many) that I really like about investments in commercial real estate is the potential for tax advantages. There are two very distinct advantages, one being the ability to defer the capital gains taxes upon the sale of the asset and the other being the sheltering of the cash flow distributions generated by the project.

The 1031 Exchange

I’ll talk about deferring the taxes first, since this is a simpler topic. The Internal Revenue Service (IRS) allows an investor to defer taxes due on the realized gains that were earned upon the sale of commercial property. This is often called a tax deferred exchange, like kind exchange, or a 1031 exchange.

There are certain rules and time limits for doing these exchanges, but generally, the seller has 45 days after the sale to identify replacement property (which may be more than one), and the seller has 180 days to actually close the transaction with the replacement property.

In the current tax code, an investor can defer these taxes ad infinitum. Assuming that the tax code doesn’t change with the changing of the guard, the big question is “how do I get access to my principal?”

This is very simple. Loan proceeds are NOT taxable. The most common way to get money out of a tax deferred investment is to borrow money against the asset. I realize that many people consider debt a bad thing, but, debt when used properly is a powerful tool.

In the case of the tax deferred exchange, we have seen projects that have returned up to 100% of the original cost bases, tax free!

Let’s take a hypthetical example: let’s assume you have a duplex that you invested in decades ago. You bought it for $200k and now it’s worth about $500k. You’re tired of the day to day maintenance and management and want to capitalize on the gains that have been earned through the appreciation of the property. You sell the property for $500k. Cost of sale was $10k and your basis was $200k, so, generally you would pay capital gains taxes on the remaining $250k. But, instead, you exchange this into another property type that has higher cash flow and less maintenance, such as a Self Storage project .

You then exchange the proceeds from the sale of your duplex, with a facilitator (kind of like an escrow agent) into this Self Storage investment. Let’s assume that the new investment was not yet stabilized and had a bridge loan, or some type of temporary financing on it when you bought into the investment. Typically, a project will take 12-36 months to stabilize or, in other words, bring up to it’s maximum potential economic occupancy.

Once this benchmark has been hit, two things happen. 1. the property has a higher value based on the increased Net Operating Income and 2. Higher financing leverage is available due to the fact that it is a stabilized asset.

Due to these factors, the bridge financing is generally paid off with a permanent loan. The permanent loan is typically higher leverage based on a higher property value. In other words, the $500k investment that you made may have bought a $1M property based on 50% leverage. After stabilization, the property may now be worth $1.5M, and the leverage may be available at 70% of that value.

The permanent financing brings in a loan of approximately $1M. After the $500k of the bridge loan is paid off, there is a surplus of loan dollars of aproximately $500k. This is returned to the investor as a tax free distribution. The project pays the debt service, so, the loan is never repaid by the investor, but rather by the cash flow from the project.

If the project is ever sold, the proceed of the sale are used to pay off the debt, and theoritically, the project is once again exchanged. Using this method you can defer taxes forever and still get access to your money.

There are a number of nuances and factors that affect the availability and amount of financing as well as the specifics of a 1031 exchange, so, even though I’ve seen deals work like the hypothetical example above, results may vary. Also, be sure to consult your tax professional before making any decisions.

Tax Sheltering of Real Estate Cash Flow

Let’s move on to the second topic… The tax treatment of cash distributions from a real estate investment that produces cash flow. I’ll start with a brief description and end with an excerpt from the EBS CPA Dan Anderson.

In general, the cash flow distributions that are distributed in a property that is held in a typical Tenant In Common (TIC) or Limited Liability Corporation (LLC) structure are not directly taxable. The excess cash flow is distributed amongst the partners or investors, but, the property pays property tax, insurance, mortgage interest, and realizes depreciation on the actual structures.

At the end of the year, each partner/investor will recieve a schedule K-1 to be included with their annual income tax reporting. What this K-1 will represent is the actual profit/loss from the operation of the business and a pro rata share of the income balanced with the tax deductible expenses. So, the depreciation, etc. will typically reduce the taxable income by a signigicant factor.

Of course, depreciation reduces your cost basis, so, the IRS will make up the loss with the sale of the property through capital gains taxes… Unless, of course, you do a 1031 exchange upon the sale. There are a lot of factors that affect the tax sheltered aspects of this cash flow, such as leverage amount, depreciable asset value, etc. But, we typically see 80-90% of the cash flow being tax sheltered in the early years of a typical Self Storage investment.

The following exerpts are from EBS’ Dan Anderson explaining the tax treatment of Cash Distributions from typical past EBS Income Investments in Self Storage:

 

 

Anticipated Taxation of Recurring Property Distributions

 

New investors commonly ask “how much additional tax will I have to pay on the cash distributions I receive from my investment in a self storage facility?”

 

In general, the answer is that you will likely pay very little income tax on the monthly or quarterly cash distributions you receive. If you are acquiring your interest in the self storage facility by means of a tax-deferred exchange, the tax results will vary depending on your tax basis in the property you relinquish in your exchange.

Cash distributions do not represent taxable rental income. Taxable rental income comprises gross rents received less expenses paid. Some cash expenditures are not deductible such as the principal pay down included in mortgage payments. The tax code provides a deduction for depreciation expense, a non-cash expense. The depreciation deduction is generally the item that offsets cash basis income and which provides for the low taxable income results.

The depreciation deduction is calculated at a rate of approximately 2.56% of the purchase price and purchase costs (”Acquisition Amount”) that are allocated to improvements, i.e., buildings. The Acquisition Amount allocated to land is not subject to depreciation.

As is typical with nearly all investments in real estate, mortgage financing provides for leveraged results. The amount of leverage depends upon the percentage of the Acquisition Amount financed by the mortgage loan. If the Acquisition Amount is paid for with a 20% down payment by investors and the remaining 80% is financed by mortgage, there is a leverage factor of 5. If the property value increased sufficiently to result in an increase of 10% of the Acquisition Amount, the investor’s equity would increase by 50% because all of the increase in equity is realized by the owners (the lender share in none of the equity increase). Similarly, leverage affects the depreciation deduction.

If the Acquisition Amount is financed 80% by loan, the depreciation deduction of 2.56% translates to 12.82% (2.56% times the leverage factor of 5). Again, land is not depreciable, so the 12.82% would be reduced to 9.62% if 25% of the Acquisition Amount is allocable to land (12.82% times 75%).

In the above example, if a project is paying a preferred dividend of 8%, all of the recurring return would be offset by depreciation deductions (9.62% in the previous example) and no tax would be payable on the distribution.

If you are involved in a Code Section 1031 tax deferred exchange, you and your tax advisor will need to determine your adjusted basis. Each tax year, we will provide you with a profit and loss statement, which shows your ownership portion of the property’s income and supplemental information informing you of additions to property and equipment.

When the property is later sold, the depreciation deductions taken during the time you held your investment will be taxed, generally at a rate of 25% federal income tax (under current law). It is possible that you may have the opportunity to receive a distribution of your ownership in the project by deed and conduct an exchange, deferring tax.

The foregoing information is a very simple illustration. Your individual results may differ and we recommend that you consult your own tax advisor.

Disclaimer: The preceding is for illustrative purposes only. Do not rely on the foregoing without contacting a tax professional. This is not an offer to buy or sell securities.