12A — October 11 - 24, 2013 — Mid Atlantic Real Estate Journal


F inancial D igest

By Stan Freeman, Exchange Strategies Corporation The Optimal Exchange Strategy – Exchange Economics


his is the second in a se- ries of articles on the sub- ject of optimizing 1031

that Mary decides to liquidate $700k in T-Bills and municipal bonds and to use the addi- tional cash to buy a different income property for $3million that also has a 6.5 CAP. Mary wants to use a 1031 exchange to preserve her capital and she has a good enough relationship with her bank so that she can borrow the remaining funds ($900k) needed to acquire the new property at a rate that is very attractive compared to its CAP rate. Mary is familiar with 1031 exchanges and knows that the following will be the situation if she starts the exchange process with a forward exchange: • Her $1.4million in equity (less closing costs) will be held by the QI until she is ready to acquire replacement property • She’ll have 45 days to iden- tify potential new property and 180 days to acquire one or more of the properties she identifies • The forward exchange fee will be between $750 and $1,500, depending on which QI she engages • The QI will pay little, if any, interest on her $1.4million • Both her rental income and her depreciation deduction will go to zero when her current property sells The real cost of this type of strategy is very high. The lack of any form of ROI on the capital being held by the QI and no depreciation deduction and means that a significant amount of money ($1.4million) will earn virtually nothing for Mary for up to 180 days. And, given the difficulty of finding high-quality $3million proper- ties with 6.5 CAP rates, it’s likely that her money will be held by the QI for most of that 180 day period. The calcula- tions are shown in the table below.

exchange. Assuming a 3-month exchange period (perhaps a bit optimistic), she’ll pay a total of $650 for the exchange. How- ever, the QI will earn a fee (say $1,000) plus some amount of in- terest on Mary’s $1.4million for 3 months. QIs earn “marketing fees” from depository banks in addition to any interest “split” that is negotiated with a par- ticular client. If, as an investor, you receive no interest from a QI on exchange proceeds the QI holds, it almost certainly true that the QI is still making money holding your money. This is how most QIs generate the bulk of their revenue. Now suppose that Mary - unhappy with the prospects of leaving her money with a QI and getting virtually nothing for it - learns that things are very different with a reverse ex- change. Specifically, she learns the following: • In a reverse, she’d buy the new property before selling the old and the QI would hold title to the new property in an LLC for her benefit during the exchange • She would continue to de- rive rent and depreciation de- ductions from her old property until it was sold AND she’d get the rental income from the new property even though title to it was being held by the QI • She’d have responsibility for the cost of operating both properties • The fee paid to the QI for the reverse exchange is higher, probably $5,000 for her situ- ation • The QI holds the cash proceeds of the sale of her old property for 1 day and then the cash is returned to her The fact that the “burdens and benefits” of both the old and the new properties belong to Mary in a reverse exchange

exchanges in today’s CRE marketplace. This series a d d r e s s e s t o p i c s o f keen interest to real estate owners and investors as

Stan Freeman

well as the brokerage, legal and accounting communities that assist them. The first article described the challenges and risks associated with 1031 exchanges in today’s inventory-constrained market for high-quality investment as- sets. Essentially, the risks asso- ciated with satisfying the 1031 deadlines for identifying and acquiring replacement property often make forward exchanges unattractive because of the relatively high risk of failure. By contrast, acquiring replace- ment property first, in the context of a reverse exchange, means that the investor has accomplished the goal of the exchange and now has to sell relinquished property to com- plete the exchange - a task that is far easier in today’s market and, therefore, carries far less risk of failure. In this article, we discuss the aspects of optimization hav- ing to do with the real cost of an exchange, ROI on invested capital during the exchange and maximizing tax deductions from depreciation. Few, if any, other 1031 Accommodators are eager to discuss this topic. The discussion will reveal some of the details of how QIs make money. It will be relatively easy to conclude that what is optimal for the QI is usually not optimal for the investor and that optimizing the exchange for the investor nearly always means minimizing the amount of time that a QI is holding the investor’s cash proceeds from the sale of relinquished property. We’ll use an example to drive the discussion. Suppose that Mary (a savvy real estate in- vestor) bought an income-pro- ducing property 5 years ago for $1million using a $600k interest-only loan and $400k in cash and that the property has a 6.5 CAP rate. Mary has been told by her Broker that the FMV of her property is now $2million and that it will be easy to sell. Suppose further

For Mary, the difference in the strategies is stunning. In the forward exchange example, there is virtually zero ROI for Mary for a period of 3 months; in fact, the exchange costs her $650. Her cash lies fallow in the hands of a QI who is making money on her money. By con- trast, if she uses a reverse ex- change she will get rents from TWO properties. Yes, she has debt service to pay on two loans but the arbitrage between the CAP rates and the cost of the debt is attractive - otherwise there would not be so many buyers for good income produc- ing real estate. And, yes, the fee for the exchange is higher but that is more than offset by the overall ROI generated by her $2.1million during the exchange period. The following table compares the two strate- gies directly. In the forward exchange, Mary is leaving a sig- nificant amount of money “on the table” and a healthy portion of that is being taken by the QI. In a reverse exchange, Mary pays a flat fee - that does not change whether her exchange lasts one month or six months - and receives the net income and depreciation deductions from her old property until it sells PLUS the net income from the new property.

attractive for Mary than in a forward exchange. Clearly, not every investor’s situation will be either this simple or this clear but it is worth the effort to make the calculation as part of determining what strategy to use. For many investors, the chal- lenge may be assembling the funds needed to make the ac- quisition of the new property before the funds from the sale of the old property are available. This is a valid objection to using reverse exchanges and some investors will have no choice but to use a forward exchange for this reason. However, many investors, when they see the potential upside, may decide that some “creativity” is called for because of the advantages of using a reverse. We have seen all of the following creative solutions applied to make a reverse exchange work: • Use other funds or borrow from a relative knowing that the funds will be “replaced” as soon as the old property sells • Arrange with the bank lender for a loan that is larger initially and stipulate that the principle will be reduced when the old property sells • Obtain reasonable bridge financing from a third-party lender using the old property

As most observant readers will see, the advantages of a reverse exchange are clear. Both pre-tax income and de- preciation deductions in a reverse exchange are far more

as collateral • Use an equity line (e.g. a HELOC) to obtain a short-term loan using other assets as col- lateral continued on next page

As shown, Mary’s income and depreciation deductions disap- pear at the start of a forward

makes the situation entirely different, as reflected in the following table:

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