Real Estate Advanced Techniques
Real Estate Investing Advanced Techniques Part I
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Oct 10, 2005, 12:35

Let's assume you own some free and clear land worth $100,000 in a rapidly developing area. You find yourself operating on a vey right cash budget and badly in need of a tax shelter. You consider trading your land for income property that will provide you with both cash flow and tax shelter. But you're reluctant to do so because you feel pretty sure the land will be worth three or four times as much in another five years.

While pondering the problem, you become acquainted with a wealthy widow, Mrs. Lodge. She is willing to accept a $50,000 crated mortgage against your land as down payment on a $200,000 income property she'd like to sell, This would permit you to acquire a tax shelter through ownership of her property, without giving up the appreciation potential of the land.

You do see one big problem, however. Although the cash flow from the property will more than cover the payments you'll have to make on the $150,000 balance of the purchase price, there won't be enough left over to take care of the payments on the $50,000 created mortgage as well. And you simply can't afford to take on additional cash obligations now. It will be a different story three years from now when your four kinds finish college and your new business reaches its full potential.

What should you do about Mrs. Lodge's offer? Accept it and hope you can scrape up the payments somehow? Or play it safe and pass up the opportunity?

Neither. Instead you offer to exchange your entire $100,000 equity interest in the land for a $50,000 equity interest in her $200,000 income property. You do this on the condition she'll grant you an option to buy the land back at any time within the next five years at the same $50,000 price plus an additional amount of, say, 12 percent compounded annually (plus taxes and other costs) for each year your option remains unexercised.

Do you see what you're doing? In effect, you're asking her to lend you $50,000 for up to five years without committing yourself to make any payments on it.

But it's not a one-say street. It will enrich Mrs. Lodge, too, if she's in no immediate need of cash. The worst that can happen to her (if you exercise your option) is that she'll get a 12 percent per annum return on the $50,000 and it will all be capital gain! If you don't exercise your option, she'll get free and clear title to land currently worth twice the $50,000 she was giving up for it. It probably will be worth much more later.

Thus, to sum things up, you'll have feathered your nest five ways at once:

1. stepped into the tax shelter you were seeking;
2. held on to the chance to profit from further fattening in the value of the land;
3. dodged any further immediate drain on your cash resource;
4. picked up some added cash flow from the income property;
5. set up a chance at another profit from improvement and resale of the income property

Trade and leaseback is another technique that has helped build financial independence for numerous investors. Here's how it works.

You own a small warehouse. It's bringing in plenty of rent money. But you need a tax shelter. Your warehouse doesn't give you the deductions you need, because it is located on valuable land that can't be depreciated; the value of your building and other improvement is too small in relation to the value of the land. (This is a common problem vexing investors who own a small building in a particularly desirable location.)

How an you hold on to as many as possible of the thousands of dollars you will otherwise be paying out in taxes? One way would be to sell your property, and buy something else for which the value of the improvements is greater in relation to the value of the land.  Another way would be to try to work the same switch through an exchange. But there is something else you might do to get even greater tax and other benefits.

If you don't need cash flow, you might consider exchanging your property for a highly leveraged position (that is, heavily mortgaged) in land that seems likely to go up in value. This would both reduce your current income and give you an additional tax savings from the interest you'd be paying. What you'd really be doing, however, is speculating on an increase in land values.

But there's a still better way, especially if you want to keep the cash flowing in. Remember that your building and the land under it can be owned, sold, or traded separately. Maybe somebody would like to own this land and lease it back to you. In exchange for your land, maybe he'll give up another investment property where the depreciable assets are comparatively high in relation to the land value. The ideal candidate for such a trade would be someone who is tired of managing his investment property, isn't in danger of uncomfortably heavy tax bills, and would prefer the steady management-free income that a long-term land lease would provide.

Would this be a good deal for you too? Yes indeed. First of all, the payments you make on the land lease can be charged off against income from other sources. You'll thus get back a good share of these rental payments in the form of lower income taxes.

Second, you'll boost your depreciation deduction delightfully. You can still take whatever deduction is available from your original property, and also charge off depreciation on the newly acquired property.

Third (assuming that you've planned your trade wisely), the cash flow from the new property should more than cover your payments on the land lease and be mostly or wholly tax-free.

Fourth, you can stand to gain in two ways if real estate values keep rising: you can gain from any increase in the rental income or resale value of the new income property you're acquiring, and you can gain the same way on the building you still own, even though you've sold and leased back the land under it.

Not too bad for a little exercise of creative financial thinking, and perhaps a few days' work!