Obtain tax deferral/portfolio diversity with 1031 and TICs

In evaluating replacement properties, it is important to emphasize the benefits of preservation of capital over cash flow when counseling clients on 1031 exchanges, tenant-in-common (TIC) investments, and Delaware Statutory Trust (DST) purchases. We are of the opinion that most of the advantages of engaging in a 1031 exchange occur when the proceeds of relinquished properties are reinvested in stable assets. As these funds continue to be reinvested in new programs, real estate investors recognize cash flow and appreciation, thereby building long term wealth. Advisors should understand that cash-on-cash is not the first or even the second or third factor to examine when evaluating an offering. Instead, advisors should scrutinize the quality of the property, sub-market, rent rolls, creditworthiness of tenants, and an array of other factors in attempting to answer the question, "Will the proceeds of our clients' investment in highly appreciated real estate be secure in the replacement properties that we recommend?" Advisors must also recognize that reinvestment in real estate is only one part of a diversified portfolio. Only after this analysis of available programs can an advisor begin to compare cash flow among offerings. This strategy favors asset stability and potential back-end appreciation over monthly cash flow. It is based on several assumptions: the idea that 25 or 50 basis points will not substantially affect cash flow from month-to-month; the concept that investors who are overly dependent on monthly cash flow may not be appropriate candidates for TIC investment; and the proposition that looking only to offerings which predict the highest cash flow is foolish, as it is easy to "manufacture" yield at the expense of the overall investment. Prior to the reality of cap rate compression, it was not difficult to find offerings which met the criteria of being solid investments in asset classes appropriate to the sub-market in which they were offered and which made sense in terms of the macroeconomic conditions of the time; in addition to having credit worthy tenants and advantageous rent rolls. In recent years, however, finding high quality offerings which also afford respectable cash flow has become challenging. It is tough nowadays to avoid looking to pro formas for cash-on-cash predictions. Financial advisors who deal in TIC investments are now forced to compete with other non-1031 offerings which project higher returns than TIC offerings. Diligent advisors crunch the numbers, calculate federal (and state) capital gains taxes and depreciation recapture liability and compare the after tax investment with the tax-deferred TIC offering at whatever yield the sponsor is predicting.The utility of 1031 will rule the day and the numbers will always come out in favor of the TIC investment. Some clients will remain nonplussed by the yield and will not invest in an illiquid security paying 6% and change - not because they need the money to live, but because they are convinced that they can do better in another (non-1031) investment. Before wishing these clients "good luck," we must remember that there are strategies which can be employed to address the issue of ensuring capital preservation while also commanding a decent income stream. All of this planning must, of course, make sense in terms of maintaining a diversified portfolio, appropriate to the age, net worth, and risk tolerance expressed by the client/investor. To be continued in the July 15 Financial Digest edition of the New York Real Estate Journal. Michael Burwick, Esq., is the president of 1031 Property Group, LLC and the chairman of its parent company, Boston Advisory Group, Inc., Hyannis, Mass. There are a multitude of theories on what makes for a balanced portfolio and how this balance should shift with prevailing economic winds. As the investment pyramid demonstrates, for investors to be truly diversified, they should have a mix of equities, fixed income, cash, real estate, and commodities, especially energy. The import of these last two components is substantial and the utility of IRC section 1031 with regard to these investments cannot be understated. Advisors know the benefits of TIC programs include geographic diversification, asset class diversification, renewed depreciation, the ability to own institutional grade real estate, to command advantageous financing, and to utilize high caliber asset and property management. Since the issuance of IRS Rev. Proc. 2002-22, advisors have had six years of history to evaluate then-existing sponsors. We have seen new entrants to the market, some who have been "one-hit wonders" and some who have become industry leaders. There were sponsors who were substantial players in 2002 but have since dropped out and others who continue to thrive. Advisors who have been in the arena for some time are now able to examine both sponsor and offering on a case-by-case basis to ascertain the most favorable vehicles for their clients' exchange proceeds. However, there remains the lingering issue of cash flow. With respect to diversification, commodities (especially energy) have become an essential element of any portfolio. Specifically germane to this discussion is the availability of 1031-compliant royalty programs. In these programs, the exchanger purchases mineral deeds to oil and natural gas deposits in the sub-surface. One offering that recently closed consisted of more than 12,500 acres. As zoning laws set the maximum density at one well per forty acres, there is the potential for more than 300 wells on the property. In this offering, there were seventeen operators. Each was a multinational, multi-billion dollar corporation. Geologic surveys - not just from the sponsor, but from the operators and from a third party engineering firm - showed more than fifty years worth of oil and gas under the surface. At the time the offering documents were written, there were sixty-four wells in place and oil was selling in the 55 to 60 dollar range. Natural gas was in the six dollar range, and the sponsor was projecting a 12.5% return based on these figures. By the time the offering hit the street, there were three additional wells in place and 59 additional drill sites. Oil was selling at more than 100 dollars and gas was approaching ten dollars. As the current geopolitical economic climate indicates an increasing demand for oil and natural gas and a diminishing supply; advisors should look at 1031-compliant investment in oil and gas royalties as a useful tool in providing portfolio diversification and increasing clients' average cash-on-cash returns. In closing, we at 1031 Property Group believe that combining TIC (or DST) real estate programs and 1031-compliant royalty programs in percentages appropriate to each investor's unique circumstances is a great strategy for deferring taxes, boosting cash flow, and remaining in quality real estate. When employed correctly, this strategy enables 1031 exchangers to stay invested in real property while also recognizing significant cash flow from the combined real estate / energy reinvestment. Michael Burwick is the President of 1031 Property Group, LLC and he is the Chairman of its parent company, Boston Advisory Group, Inc. Mr. Burwick is a registered representative of Advisory Group Equity Services, Ltd. Member: FINRA/SIPC, and is an investment advisory representative of Trust Advisory Group, Ltd. a Register Investment Advisor.