Real Estate Advanced Techniques
Strategies for Sophisticated Real Estate Investors – Part II
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Oct 10, 2005, 11:03

A broker friend of mine once met one of these people. The broker's client owned land worth $240,000 which he wanted to trade for a small industrial building. a $180,000 mortgage was owed against the land, so the client had a $60,000 equity to work with.

Another broker in the same town knew a woman who owned an industrial building free and clear. She was looking for a chance to trade it for land. And she happened to want exactly the kind of land my broker friend's client owned. Moreover, the value of the industrial building was virtually identical with the value of the land - making a trade seem all the more feasible. All that was needed to equalize the equities was for the landowner to give the woman a $180,000 purchase-money first mortgage for the difference.

But the woman wouldn't accept a mortgage as part of the trade. Nor would she assume responsibility for the existing mortgage on the land. Unless she could have the land free and clear, she didn't want it.

The landowner couldn't come close to raising $180,000 to pay off the land mortgage before the trade. But a little imagination and resourcefulness paid off. My broker friend and I went to see the man who held the mortgage on the land. We found, as I suspected, that he was delighted to exchange his mortgage for what he regarded as a much more secure similar mortgage on the industrial property. So the woman got her land free and clear - with no payments or collections to be made on mortgages of any kind - and my friend's client got the industrial building on which he continued to make payments to the same creditor as before.

Boot can be a troublesome question when you're trying to arrange a tax-free exchange. since boot is taxable to the extent of any gain being realized, the party receiving it may want to back out. Often there is no way to eliminate boot or reduce it to an acceptable level. But sometimes what appears to be impossible can be done.

Suppose, for instance, you've been investing in residential property for some years, and now include among your holdings a free and clear apartment building worth $275,000. But the properties are getting burdensome because they make you spend too much time on managerial details. So you'd like to trade the apartment house for some other income-producing property that will be simpler to manage. You tell your broker this, and he starts searching.

He finds a Mr. Steel, owner of a small industrial building, who would like to trade for an apartment house of the type you're offering. Everything seems to fit perfectly. Mr. Steel's building is leased to a strong national company for the next twenty years. You can just sit back and watch the cash roll in without any bothersome detail work. Its fair market value, based on the income it produces, is $425,000. Mr. Steel owes $150,000 on the mortgage against it, so his equity is $175,000 - exactly the same as your equity in the apartment house. What could be sweeter?

You and Steel inspect each other's property. You both like what you see. You agree in principle to the proposed exchange. 

But then Mr. Steel's accountant points out that he'll make a profit on the exchange, and that $150,000 (the value of the mortgage you'll be taking over) will be taxable as long-term gain. Mr. Steel is shocked. He's already in such a high tax bracket that the exchange would cost him $42,000 in taxes to Uncle Sam, and several thousand more to the state.

He tells you its all off. He just can't afford to pay out that much money in taxes. It would more than offset any advantage he expected to get from the exchange.

So you and your broker grope for some way to eliminate or drastically reduce the mortgage-relief boot.

Should you take out a $150,000 mortgage loan on the apartment house, to equalize mortgage debt and eliminate boot? No, because this would reduce your equity in the apartment house to $125,000 as compared with his equity of $275,000, and you'd have to make up the $150,000 difference in some other form of boot. Thus Mr. Steel would owe just as much tax as he would with the mortgage relief.

Should you try to find some way for him to pay off his $150,000 mortgage before the exchange? No, because even if you could arrange it, this would simply increase his equity to $425,000 as compared with your equity of $275,000 - leaving you both with essentially the same problem but less money to work with.

But at last a brilliant ideal dawns on you. Why not try to borrow that $150,000 on your apartment house to eliminate the mortgage boot (as you'd previously considered) but with a starting difference? Instead of paying this $150,000 to Mr. Steel, why not use it to buy free and clear another apartment house Mr. Steel might want? This would enable you to limit the entire exchange to properties of like kind - with no net mortgage relief or other boot to be received by either party and therefore no taxes! He'd be getting $425,000 worth of qualifying property with a $150,000 mortgage on it and you'd be getting the same!

The other creative ideas come to your mind. What if you find you can borrow only $100,000 against your apartment house? No problem! You'll still buy another $150,000 apartment house, but with a $50,000 mortgage against it instead of 100 percent cash. This would still offset $150,000 in mortgage debt on the one property with $150,000 in mortgage debt on the other two properties - so, again, there'll be no mortgage relief and no tax bill for either you or Mr. Steel.

Even this isn't necessarily the best possible solution. Suddenly you realize that you may not have to borrow directly at all. Instead, you can simply create a mortgage against your original apartment property. You can use this mortgage as part or full payment of the new $150,000 property, taking out a purchase money mortgage to finance whatever balance may be needed.

Doing this is surprisingly easy. You just pick up some mortgage forms from a stationery store, put them in a typewriter, and type up a mortgage on your own property in favor of the owner of the property you want to buy. If you're not sure how to fill in the blanks, or how to word the terms, your banker or an escrow company will be glad to prepare the papers for you, charging a fee of only $10 or so. Normally you won't have to pay any points, and you'll escape most of the other charges that woudl be tacked on if you borrowed in the usual way. Better still, you'll probably have much more room to negotiate provisions favorable to you than you would with an outside lender.

If the owner of the property is willing to go along, this creation could be the best solution for both of you.

Two dollars can do the work of four when they're in the form of mortgage notes instead of cash. What I mean by this paradox is that you can often use existing mortgage notes at face value in exchanges, even though the same notes would be sharply discounted if you sold them for cash. This can sometimes give you a chance to turn a profit of as much as 50 percent virtually overnight.

Let's assume you've got $12,000 in cash, and want to invest it in income-producing real estate. You figure that this much money can probably make you the owner of a property worth at least $60,000.

But  you can really do much better than that, if you know how.

Instead of beginning with a direct purchase of property, you can scan the "Mortgages and Trust Deeds for Sale" ads in the papers. Or you can make a few inquiries among builders and Realtors. You'll almost certainly find that you can buy one or more high-quality mortgages or trust deeds having a total face value of as much as $24,000 with the same $12,000 cash.

Then you go looking for property. Instead of cash, you offer your newly bought mortgages or trust deeds in exchange for a $24,000 equity in real estate worth perhaps as much as $120,000. This has been done many times.

Even though most sellers want cash down payments, there are always some who don't need cash and would much prefer to watch the dollars roll in every month from a properly secured mortgage or trust deed note. If they took cash on the sale, they'd simply put it into a savings account at much lower interest than they can collect from your realty notes.