One question I am regularly asked by clients who are selling their investment real estate property is if there is a way to achieve the following goals: (1) enter into a 1031 exchange, but at a smaller amount than required under the law because they want to reduce their real estate holdings in their investment portfolio; (2) receive some cash out; and (3) and deferring taxes on the cash-out. The answer is yes, if you structure your assets correctly before you sell.
Let’s take, for example, Client A wishes to sell his $10 million-dollar real estate property (RE), owned wholly by his LLC. The RE has a $4 million dollar mortgage and the A wants at least $2 million dollars to enter into other non-real estate investment.
The Banker’s Solution
The most common solution presented to clients is one that I refer to as the “Banker’s Solution.” This solution is relatively simple: (1) Sell the RE through a 1031 exchange; and (2) After acquiring a $10 million dollar replacement property, refinance the property and take out $2 million dollars in additional loans. This solution achieves most of the client’s goals: it allows for the client to cash out of $2 million dollars and achieves deferring taxes on the cash-out. However, the client still owns a $10 million dollars property but now has to service $6 million in total debt ($4 million from the 1031 exchange and $2 million from the refinance).
The Tax Attorney’s Solution
The alternative strategy is what I refer to as the “Tax Attorney’s Solution.” This solution, although a bit more complicated, can achieve the goals of the client. First, in order to maximize options, A would have to “split” the ownership of his deeds so that the property is owned by 2 entities as a Tenancy in Common. For example, the client finds a replacement property worth $6 million dollars and doesn’t want to purchase any other real estate. Prior to the sale of the RE, A would split ownership of the RE as such: 60% LLC and 40% A as a tenancy in common. This split allows for the LLC to still enter into a 1031 exchange, but also allows for A to enter into a monetized installment sale. Note, the debt would be split pro-rata amongst the RE owners ($2.4 million would be allocated to the LLC and $1.6 would be allocated to A).
The 1031 exchange
The LLC would enter into a normal 1031 exchange whereby it would acquire the $6 million dollar exchange property and acquire $2.4 million of debt per the 1031 rules. The client’s goal of entering into a smaller 1031 exchange is solved.
The Monetized Installment Sale (MIS)
An MIS is a specialized transaction whereby A sells his 40% interest in the RE to a Third-Party Purchaser (TPP) and receives a 30-year, interest-only, promissory note, achieving tax deferral until the TPP pays the principal on the note. After the sale, A acquires an interest-only, unsecured loan, equivalent to 95% of the promissory note. The interest paid to A by the TPP is used to pay the lender its interest (it is structured to offset). After 30 years, TPP pays to A, 95% of the promissory note’s value, in which A uses to pay back the lender. A, when paid its principal, owes taxes to the IRS.
By entering into an MIS transition, A would receive a gross loan of $3.8 million, of which $1.4 million would be used to pay off A’s portion of the debt on the RE. After paying off the debt, A would have $2.4 million in loan proceeds that can be used for other investment purposes. The client’s goals of cashing out of at least $2 million and deferring taxes on the cash out are solved.
Although the Banker’s Solution offered the tax deferral on the sale using the 1031 exchange, it does not solve the stated goals of the client. The client owns $10 million in new real estate, but the client has to service the debt on $6 million out of pocket.
However, by using the Tax Attorney’s Solution, the client achieves all of their stated goals: (1) purchased a smaller 1031 exchange property, thereby decreasing their real estate portfolio; (2) only have to service $2.4 million of debt rather because the other debt is being serviced by the TPP’s interest payments; and (3) client has $2.4 million in cash that can be used for other investments. Note, the client still has to pay the taxes on the $3.8 million dollar sale in year 30 but has 30 years to reinvest the $2.4 million in cash, which if invested correctly, should yield a significant multiple on their reinvestment.