Real Estate Advanced Techniques
Strategies for Sophisticated Real Estate Investors – Part I
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Oct 10, 2005, 00:50

You can do two things to lessen the chance of looking like a dealer. One is to state very clearly, in the papers you submit when you buy a property, that you’re buying it for investment purposes or for your personal investment portfolio. The second is to act like an investor, not like a dealer. Actions speak louder than any words you write. If you buy and sell too often in too short a time, you’ll be running a high risk of being classified as a professional real estate dealer.

This is another reason why you’re better off to keep your sales transactions to a minimum and trade wherever possible. But try not to trade each property individually. Put together a package of four, five, six, or seven of them and trade these for one big building. Maybe the big building’s owner doesn’t want your smaller properties, but you’ve already seen how to overcome this obstacle. You tell your broker to find other parties to take over the properties from their new owner as soon as the exchange has been completed. You thus pack several transactions into one. You also strengthen your image as an investor.

Using the depreciation is one of the most important techniques that make real estate investors wealthy. You get a substantial tax shelter through the depreciation allowances you can take on buildings, equipment, and furnishings.

Take a look at the depreciable improvements, too, when you’re sizing up a property you might want to trade for. Are they large, or smaller, in relation to the value of thee land under the property you now own? You remember, of course, that land can’t be depreciated. So if you trade for a property where the value of the depreciable improvements is relatively greater as compared with the land, you can cut your tax bill further.

In general, the best way to boost your depreciation allowances is to trade up. Stated as simply as possible, your new property’s tax basis will be its fair market value minus any gain on the old property that hasn’t been recognized for tax purposes. Or, stated in a much more roundabout way, it will be:

1. The adjusted basis of the old property;
2. PLUS boot given;
3. MINUS boot received;
4. PLUS mortgages you assume on new property;
5. MINUS mortgages on your old property;
6. PLUS any taxed gain on old property.

Here’s an example. Suppose the property you now own has a tax basis of $20,000, a market value of $50,000, and a mortgage debt of $10,000 outstanding against it. You exchange this property for one worth $140,000 encumbered by a $95,000 mortgage, which you assume. To make up the difference in equities you toss in cash boot of $5,000. the exchange will be totally tax-free to you, because you get no net mortgage relief or other boot.

By such a trade, you rake in a bonanza. You now own a property three times as valuable as the old one, and presumably with a net operating income some three times as great. In addition, you’ve upped your tax basis from $20,000 to $110,000 – entitling you to take several times as much annual depreciation on your future tax returns.

You can determine your new tax basis by either of the two methods mentioned above. If you use the first, simply subtract your unrecognized gain of $30,000 (the $50,000 fair market value of the property you traded away, minus its $20,000 tax basis) from the $140,000 fair market value of the property you acquire.

If you use the second, you add to the $20,000 basis of your old property the $95,000 mortgage you’re taking on, and the $5,000 in cash you’re coughing up as boot; from this total you subtract the $10,000 debt you’re getting rid of. The basis of the property isn’t affected by your profit on the old, because you won’t be paying any tax on this gain.

Is it always better to exchange? Some real estate people will contend that in a situation like the one above it might be better to sell the old property, pay the capital gains tax on the profit, and buy the new in a separate transaction. Their reasoning might run something like this:

You would fatten the tax basis of the property you were acquiring from $110,000 to $140,000, thereby swelling the depreciation you could ultimately take on the new property proportionately, and

You would be paying a tax on your gain at capital gains rates (that is, generally paying tax on only half your gain at whatever ordinary tax rates would apply) while being able to deduct every dollar of whatever additional depreciation you could take from future income.

They could be right from a strictly tax angel – depending mostly on how the gain would affect your tax bracket in the year or years you’d be liable for taxes on it, and what your income might otherwise be in the years in which you’d be taking the extra depreciation. But you should look at other angles besides taxes. Whether you sell your old property on terms that render the gain immediately taxable or qualify the sale for installment treatment, you’ll have much less available to reinvest than if you exchange. In fact, there might be a serious question as to whether you’d be able to buy the new property at all. You might find the owner was still expecting a down payment of $40,000, while all you could scrape up after considering your liability for taxes and / or the borrowing power or discount value of your paper was $32,500. Whatever the circumstances, you wouldn’t be able to control as valuable a property on reinvesting, nor could you step up to the same high tax basis you were seeking.

A dollar now is worth much more to you than a dollar one year or ten years from now, if only because of what you can earn with it in the meantime. It might take you ten, fifteen, or twenty years to save as much in taxes from an additional depreciation deduction as you’d pay out in taxes if you were to sell instead of exchange. And this isn’t even considering the value of the additional property you could probably acquire with the tax money in the meantime!

All this, of course, is one more reason for having a competent tax consultant (and preferably one who works extensively in real estate matters) review and advise you on any contemplated sale, exchange, or purchase of real estate. I can state only general principles here. There could be situation where, despite the advantages I have mentioned, a sale instead of an exchange would be better for you.

One such situation might be where you’re disposing of property at a loss. Losses realized in qualified exchanges aren’t counted for income tax purposes, and any boot received in the exchange merely results in an adjustment to the tax basis of the property being exchanged. If y our other income is such that you can take advantage of the loss, you’ll probably be better off selling the old property and buying the new in separate transactions.