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Handling an Exchange Where the Seller Has Already Cashed out Much of His Equity Through Refinancing.

The Story.   John had owned a 40-unit multi-family property for many years.   He acquired the property for $1,000,000.  Over the years, John would refinance the property several times to take cash out for other investments.   One day, John got an offer he couldn’t refuse, and accepted a contract to sell the property for $3,000,000.   By this time, he owed $2million on the building, representing a 66% LTV (the debt on the property/sales price of the property).    His net proceeds from the sale would be only $1,000,000.  Of course, John was benefitting from the cash he pulled out along the way to make other real estate investments, but the day of reckoning was about to arrive.

John wants to avoid paying tax on the sale of his property which could be devastating.  His adjusted tax basis after depreciation is now $100,000, so his gain would be $2.9 million resulting in a tax liability between Federal and State taxes exceeding $900,000…almost as much as the cash he would receive from the sale.   Clearly, John wanted to do all he could to avoid that result.

The Problem.   After John pays off the mortgage on the property, he will have only $1million in net proceeds.    To achieve a fully deferred exchange under Section 1031, he needs to reinvest the $1million in cash and replace $2million in debt he paid off when he sold the property.  Unfortunately, there are very few replacement property options with the necessary 66% leverage he would need

Two Solutions Proposed:

  • Zero Coupon DST. These are properties specially designed with very high leverage by structuring the cash flow on the property to pay only the debt service on the mortgage.  So, there is no cash flow to the investor.   Some ‘zeroes” will have debt as high as 85% LTV.   For $300,000 of his sale proceeds, John could ‘buy” enough debt to satisfy his entire $2million debt replacement requirement and still have $700,000 to invested in an all cash  DST earning him $35,000 annually based on a 5% cash flow.  He would solve his tax issue, and when combined with the 7% he was earning on the $2million he had already cashed out and invested years ago, he was now earning a healthy portfolio return of 6.48% on $2.7 million.
  • Another Approach By finding John a leveraged cash flowing DST paying 5% with a 45% LTV, we could optimize his cash flow by using only the minimum amount of the zero required to satisfy his debt requirement beyond the 45% LTV of the cash flowing DST.  So, by investing only $245,000 in the zero with the balance of $755,000 going into the cash flowing DST, the result is a 3.78% return o slightly improved portfolio return of 6.72% on $2.755mm equity, a marginal 3.7% increase in cash flow by optimizing the two investments.
  • John chose the first approach because he preferred the demographics of all cash DST.