Zero cash flow properties and the 1031 exchange: A smart cash-out option for real estate investors

Real estate investors who have either inherited real estate or who no longer want to be active in real estate management are often faced with a dilemma. They want to cash out from their real estate but don't want to deal with a looming capital gains tax due to low basis in the property. While many investors choose to sell and succumb to the tax hit, there is another option that provides higher after- tax cash receipts and still allows for a substantial return in real estate. For investors looking to pull equity out of their real estate, a 1031 exchange to a Credit Tenant Lease (CTL) property may be the best option. The process of a 1031 cash-out is similar to any other 1031 with one additional financing piece. In this type of exchange, an owner sells their current property, replaces it with a net-leased property, and after the exchange is completed, secures credit tenant financing for up to 90% of the property's value. A 1031 transaction is where an owner of real estate sells their property and within 180 days uses the sale proceeds to purchase another piece of real estate. If the transaction is completed during that period, the seller will be able to defer capital gains tax. This exchange is crucial for sellers who want to remain in real estate or are looking to trade up to larger properties or to diversify to multiple properties. Net-leased properties are unique in real estate, wherein the tenant agrees, in addition to rent, to pay all real estate taxes, insurance, and property maintenance. This leaves the property owner's cash flow free from expenses other than financing expenses. Single-tenant net leased properties are generally leased by large investment-grade corporations for long periods of time, typically at least 15 years. These properties are usually leased by retail tenants such as drug stores, bank branches, and automotive stores. Credit tenant financing is a special form of financing limited to tenants of investment-grade credit, at least BBB or equivalent, leasing single tenant net-leased properties. This special form of financing essentially finances the lease and not the actual real estate itself. These loans require long-term leases, typically at least 20 years. The most unique feature of CTL financing is the ability to consistently leverage 90% and even higher, in some cases. This type of financing matches the lease payments to mortgage payments so that the property becomes a "zero cash-flow property." This allows for much higher leverage levels than traditional financing. In a 1031 cash-out scenario, an owner would sell their current piece of real estate and enter into a 1031 exchange. During the first 45 days after selling their relinquished property, the owner can identify up to three replacement properties. To utilize CTL financing, the owner should look to high credit tenants such as CVS or Walgreens, and in order to maximize the tax benefits, should look for a property of equal price to the relinquished property. The seller will have up to 180 days to close on the property to effectuate the 1031 exchange. The acquisition of the new property must be completed within 180 days or the prior transaction will be deemed a sale and become a taxable event. Once the acquisition of the property is completed, the owner may then place CTL financing on the property and "pull-out" the loan proceeds. For example: (This example will exclude buying and selling expenses.) A couple has inherited a $5 million apartment building that has been fully depreciated. The couple wants to buy a new house and wants the equity from their rental property. If they simply choose to sell, they will face depreciation recapture for the full value, which will be taxed 25%. After taxes, the couple will receive net proceeds of $3.75 million and will no longer have real estate as an asset. However, if the couple chooses to enter into a 1031 exchange, the process would look like this: they sell the rental property for $5 million and enter into a 1031 exchange. During the first 45 days after the sale, the couple will identify two or three Walgreens or CVS properties priced as close to $5 million as possible. After completing the exchange and once the couple owns the new property, they will place CTL financing on the property at 90% leverage. When the loan is in place, the couple will receive funds of $4.5 million. Since this is a financing activity and not a sale, the revenue is not taxable. The new property with CTL financing will not produce any cash flow. However, over the course of five years, the total principal reduction, assuming a sale price equal to purchase price, will yield an effective 17% annual rate of return on the $500,000 invested equity. The final benefit is an additional $750,000 in net proceeds to the couple as well as a 17% annual rate of return in the newly acquired property....this is a smart cash out!!!! Marilyn Kane is the president and Sean Shanahan is the CFO at Iridium Capital, New York, N.Y.