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larrywww

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Reply with quote  #1 

Why do I like the seller financing?  Because even in the worst scenario I get back my own property (which I know is a quality property with quality tenants, etc) at a discount (the amount of the down payment paid)----so that even if this occurs in a down  market I am relatively speaking somewhat secure.  And since I want to exit the overvalued real estate market, I am NOT doing a 1031 into other real estate (which would probably be overvalued, etc).

But there are ALOT of obstacles to this sunny scenario.  (I think seller financing is very viable, but less so for 1031 money).

So, I want to avoid taxes to the fullest extent possible, but probably can't avoid:

1. Recapture of depreciation (which is taxed at 25%).  (You can NOT avoid this without a true 1031).
2. Maybe the Medicare Tax 
3. You can postpone the balance of the seller financing, but whatever you receive in this year will be taxable.
4. Also California income tax, to the extent applicable.

The Medicare (and related taxes) are described as follows:

"Medicare Taxes 
The additional 0.9 percent Medicare tax on wages above $200,000 for individuals ($250,000 married filing jointly), which went into effect in 2013, remains in effect for 2018, as does the Medicare tax of 3.8 percent on investment (unearned) income for single taxpayers with modified adjusted gross income (AGI) more than $200,000 ($250,000 joint filers). Investment income includes dividends, interest, rents, royalties, gains from the disposition of property, and certain passive activity income. Estates, trusts, and self-employed individuals are all liable for the new tax.
But what I do NOT want to add to the list is the earnest deposit which might be 30% or 40% (even though taxed at a lower rate than recapture)."

The basic problem is that the 30% down payment is going to be boot and thus taxable.  Also, the rule is that you want to invest 100% of the proceeds or face taxes----and it certainly looks like you are NOT investing 70% of the total value, which would be a problem.  (I'm not sure that title is going to be thrilled with the fractional interest---even though it is ultimately recombined later).

So here are the options:

1. 1031 the real property in exchange for the down payment and the seller finance.  But I don't believe the seller finance is "like kind"----so maybe that won't work.  The note is considered personal property and not real property.  (I have since spoken to a CPA---he says this isn't a problem---you can defer your gain this way).

2. So, what if I sold 30% of the property, closed that escrow, and then did a 2nd escrow where I did the seller finance.  Whether I need a double escrow or not I'm not sure---but that is one option.

This way in the 1st escrow I am investing 100% of the proceeds---and at least that isn't taxed.   In this way, the Hud1 will show to the exchange company a 100% investment of proceeds.

I don't really like the idea of doing fractional interests---But something has to close to complete the 1031 requirement. 

3. Or maybe I sell 1 unit out of a 5 units in the first escrow---and then later finish the seller carry in a 2nd escrow.

4. Can you stagger the down payment into several years and hand it over to a servicing company?

5. Can you take an interest in the buyer's property as security rather than getting the large down payment?

Why am I going to such lengths to do this?  Because I am not afraid of the property coming back to me (after a substantial down payment)----and this is way better than  trying to buy a completely new property, being forced to rehab it, basically starting all over (once again).  At least this will slow down the process so I can handle things better.


Would this work?  Or is there any better way?

The problem is if you add this substantial down payment to the boot column it's gong to make the taxes so high I might be forced to abandon the whole idea.

The funny thing about all of this----it is accepted wisdom about how helpful it is for sellers to have seller financing, but if  you combine that with a 1031 exchange it starts to get very complicated.  I really am not comfortable with what has been suggested so far, but it's so far the best I can come up with.

It's kind of absurd to do a partial transfer when it is followed up by a complete transfer, and I'm not sure title would even insure that transfer, but it would solve the other proble

Or maybe the down payment could be staggered over several years while held by a servicing company.

Or maybe we could take an interest in the seller's other property.

Or maybe it needs to just be a lease option since the problems come in with the change of title.  In which case, I am abandoning the idea of doing a 1031 at all (until the option is exercised).

I like the idea of doing seller financing and stretching the payments over many years to lessen the tax impact.  But if I receive too much income in the first tax year, I will pay alot of taxes.  So I haven't quite figured out how to structure it.

You can always invest in DSTs (Delaware Statutory Trusts)----and in one respect I see the market niche that they fill.  They permit you to do a 1031 and pay no taxes, even if you have zero control and everything is managed by a management company.   Alot of the promoters who hawk these things get a nice fee for doing the transaction and then exit from the deal almost immediately.  This is Wall Street you are dealing with----so of course there is ZERO TRUST in this situation.  You can so do "due diligence"---of course----they have a Private Placement Memorandum or its equivalent----but it's hundreds of pages long and it's designed so if you do the deal you can NOT sue.  With a DST (unlike a TIC, which because lenders won't lend to them in many instances) you have no voting rights, no control, you have no choice when to exit the investment.  There is a rule with DST that the period can't be longer than 10 years---but you don't control when you exit.  Also, your interest in the DST is NOT liquid----it's not like a stock you can sell----there is NO established market for selling such interests.

However, it's arguably better to do a DST than pay taxes because even if the returns are low (5% to 6%) at least you won't have to manage them and there is a chance you can segue into a down market after the current market has crashed with your principal intact.  Look at it this way---if you are going to pay taxes then you are getting zero return from that money----even if lost 100% of your DST investment the outcome may be no worse than paying the taxes.

But it may not be so easy to get the EXACT interest in a DST that will zero out your taxes.  There is a 1031 that says you MUST invest 100% of the proceeds---and matching the proceeds to the exact amount that will yield you zero taxes may not be so easy.  You may need some little deals to go along with your big deals to plug the holes.  Even if you are engaged in a 1031 transaction and you have some small amount of boot----Bill Exeter once remarked that if you really want to pay zero taxes the type of DSTs are great "deal fillers" to structure the transactiona and taxes in a way that you prefer.


I still respect those who pay taxes, but this requires planning.  To do this efficiently and not get a monster hit in one tax year, you will need a multiyear strategy BEFORE you sell.  Most real estate owners start out with a 1031 thinking they will love managing real estate forever---and for many it works out that way---but not all.

The beauty of the DST, BTW, is that you can have your accountant do your taxes---and let's say his conclusion is that you will have to pay $158,334.00----just to use a random figure.  Most DSTs can accomodate the odd amounts---so you pay no taxes.  

There is another advantage to the DST:  You continue to have the right to use depreciation which will cancel out a certain amount of gain----and may also serve to cross out a certain amount of the depreciation recapture and other taxes.  That is a serious advantage, as most investors know.  (One thing you always need to figure out: Maybe I have had losses in other years that I can repatriate to the current tax year----I am not an MBA so I am not 100% sure that is still available under the new tax law.  But you should always do the math with your tax advisor first so that you can figure out your real tax liability.  A smart way to pay taxes is to pay the exact amount each year that is otherwise covered by your depreciation and/or other real estate losses---since you are still paying zero.

But I think that the way most owners are they get burned out with managing real estate and at some point and just want to sell all or most of everything---also because they think the market  could tank soon.

The other thing I've heard about is investing in an upreit (the formation of a REIT, essentially).  Generally speaking, this will turn your real estate into an interest in a REIT.  The advantage at that point is that it might be publicly traded.   But this does NOT permit a 1031----it cashes out your real estate into stock----which is NOT like kind.  The ONLY investors that I have ever heard that do this commonly are those who are very elderly----say maybe 75 or older.  Their attitude is that once a tax catastrophe is generated they will be graduated from this world.  But for those who are NOT in this position this is frequently NOT a good choice---a DST is superior in this regard.  

Before investing in a DST I would investigate their fee structure (which means digging through the prospectus, etc).  A similar product frequently sold by the same agents is a syndication.  The sponsor fee is frequently 1% but more frequently 2 to 5% acquisition fee.  They also are frequently combined with anywhere from 25% to 50% of the profit when it closes (even if they haven't invested any of their money).  And then there are property management and other fees.  It's no wonder that alot of these products get milked to such an extent that the return for investors isn't nearly necessarily----maybe even routinely----is NOT what was advertised.   It's not easy to rate these products since there is no market for resale---which would presumably indicate how satisfied (or desperate) existing customers are.  It would be better if you only subscribed with those investments where investors are paid off before the sponsors are compensated----but it may be hard to find those---or figure out when this is the deal structure.

I have just read through a  prospectus for a DST and I must say I am APPALLED.  Actually, what I said earlier about being able to 1031 with a DST is in need of serious qualification, depending on the prospectus and what happens with the investment.

Thus, this particular investment included the follwing terms (which includes the option to transform it into a "springing llc" which means, at that point, it will not longer be a DST that will qualify for 1031 treatment):

1. They indicate that investors have zero control over management and no voting rights.  Also, the investors may receive zero return.  (So, when they talked about a return of 5 to 6% this was a PROJECTION---no legally enforceable right to ANY return).
2. The Investment Manager is an affiliate of the Master Tenant so it will have a clear conflict of interest in pursuing any legal remedies against the Master Tenant if they default.  In fact, the Master Tenant and Manager were specifically created to manage and occupy this investment with very limited funds.  To me, this is really bizarre----the manager is an affiliate of the Master Tenant????!!!!!!   Who operates like this?  This sounds like a total scam.  Since when does the Tenant manage the property?  Normally, a manager is supposed to do due diligence in terms of the choice of tenants---but in this case, what---the tenant is supposed to due diligence on themselves?  On what planet does that happen?  It sounds like the managers have leased the entire project to themselves to insure that it will be managed for their benefit.
3. Although I heard this was a 5 or 6 year investment, the paperwork said that it was a 10 year investment;
4. The Trust Manager, Master Tenant and their affiliates have a limited history of operations, limited experience managing DSTs and have limited capital.
5. The salesman said that the sponsor was investing 1 million dollars, though half of that was a promissory note and this was on a 40 million dollar project, so they really only have 2.5% cash at stake.
6. Although it was touted that investors in this DST could do a 1031, they also contained a clause that stated that if the investment is transferred into a Springing LLC then investors will lose their ability to do a future 1031 of their interests.  (This makes it EXACTLY like the upreit situation).  Apparently, a provision exists so that if there is a danger the property will be somehow lost then the managers can transform it into an llc with pre agreed upon terms (a so called "Springing llc") which will permit the managers to raise more capital and/or negotiate the debt, so that the structure of the investment will no longer qualify for DST treatment.  Apparently, if the managers manage the investment in such an appalling manner that they are in danger of losing the property to the investors they can pull out the springing llc and then liquidate the project in a manner they prefer---even if investors do NOT.
The Springing LLC  clause is primarily applicable to those offerings that have debt.  The problem is that if you want to refinance you are forced to convert into an llc to do a refinance because the tenant is defaulting, and/or the lender isn't going to extend the current loan without changing it.  I have been informed that if you invest in a free and clear type offering this wouldn't normally occur.  
7. They expressly state that there is no public market for these investment interests.
8. The Trust Manager and its affiliates will receive substantial compensation from the ongoing management and operation of the project---so what is their incentive for every stopping the gravy train, as it were.  I can NOT even find where the incentives are in this massive document, but I am SURE they are there.
10. There is no requirement of return of investment since the investment is subject to the same contingencies that the market may impose on any real estate investment
11. The loan imposes cash sweeps in the event of certain occurrences.  I admit it, I had to look up what a "Cash sweep" was---but apparently all of the money involved in the project can be collected before any distributions are made in the event of tenant default, bankruptcy, etc.
12. They also have a non recourse carve out guarantee which means: A nonrecourse carveout guarantee is a guarantee of certain acts or omissions of the borrower in connection with a secured real estate loan where the guarantor is not liable, or is only partially liable, for repayment of the principal and interest on the loan.
13. There is a privacy clause prohibiting investors from comparing notes with fellow investors----and an investor who violates the privacy clause may be sued to return all distributions made to him/her.  Even if you wanted to compare notes, there is NO way to find the other investors unless the manager cooperates---which is unlikely.
14. My understanding is that if the property doesn't sell within 10 years then it must turn into an LLC---and the buyer can no longer do a 1031.  Alot of these properties may have difficulty getting financing and/or the lender doesn't want to renew their loans. 
15.   Also, the trigger point for what happens on this investment is that property in most instances will ultimately be sold----and this is what I have difficulty imagining----how can they possibly believe the price is going to be any better than the currently inflated price?  I am informed that a free and clear property isn't going to be forced to sell as quickly as a financed property, but this may mean that the delay in selling may be interminable, especially if we hit a seriously bad economic situation.  What you see in the DST space are alot of value added and turnaround deals.  But I am skeptical.  In 2007, alot of properties types experienced the highest valuations ever.  Right now the valuations stand to go even higher.  Do these brokers really believe that these are bulletproof transactions?  They say Yes, but I really think that they have told the property owners that the market is going to tank and the best way to cushion a soft landing is to indefinitely tie up a group of unsophisticated investors so that they don't lose money.  If the property ultimately sells for less than as valued in the original offering, the investors will be forced to take the loss.  Part of the sales pitch is frequently about the NNN leases---but this is a function of the economic strength of the company in question.  Not many forsaw Toys R Us heading into bankruptcy.  Also, the very fact that the company doing the lease has economic strength frequently means they have a provision in their lease that will let them duck out at a moment's notice with very little downside.  Having been a commercial leasing agent, I know this.

God, this is why people HATE Wall Street.  Everything is so opaque, nothing is clear, you are dealing with (in some instances) billion dollar companies---and I can't shake the feeling that you are guaranteeing the weakest parts of their inventory.   I'm not sure what I expected, but it seems unbelievably one sided.  I recall the huge fight in repealing the "best interests" standard for financial advisors that required them to make investments with this standard in mind---but that is NOT the way they like to do business.

I am hoping that this particular DST is NOT representative of the field, but am unsure at this point.  The truth is that all of these representatives seem to have pretty much the same deals---you just have to decide which representative you want to do business with.  We are advised to read the initial offering memoranda in order to do due diligence----but I think you will quickly find out that the paperwork is almost identical from deal to deal----once the industry figures out the most one sided way to write it up, that becomes THE standard.  The specifics of the deal may change----but your rights in this situation almost seem like mirror images.

Paying the taxes and/or doing an imperfect seller carry is starting to look more and more attractive.  I guess it boils down to whom you hate more---the taxing authorities or Wall Street.  If they at least gave a firm termination date and/or guaranteed at least to return the principal, this might be a better deal.  But increasingly this commitment looks like a blank check to me.  The whole idea of selling now is to avoid the market crash that you KNOW is coming---but the way this deal is structured this totally defeats the entire purpose of selling now.

Here endeth the rant!

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