Since 2003, one of my valuable 1031 Exchange solutions has been what I call a “Combo Exchange.” A Combo Exchange comes in handy while managing the debt replacement requirements of a 1031 Exchange.

In such an exchange, we will mix higher-leveraged properties with lower-leveraged or ALL-CASH ones to meet an investor’s 1031 Loan to Value needs or to seek certain income or growth potential goals. This month, we will explore another available tool: a “Zero Coupon” property. These very highly-leveraged offerings can give my clients excellent flexibility and potentially offer more income and growth potential.

A review of 1031 Exchange Requirements

My readers will recall that, to achieve a completely tax-deferred (potentially forever) exchange, a 1031 investor must spend all of the equity proceeds that he receives from a sale and assume a loan that is equal or greater than the loan he paid off. An investor who sells a $2 million property and pays off a $1,600,000 loan must find a replacement property with at least an 80% ($1,600,000 / $2,000,000) loan-to-value (LTV) ratio, or a 20% down payment. It can be hard to find a loan for an investment property with only a 20% down payment. This month, I will highlight a potential solution for such cases.

Highly-Leveraged “Zero Coupon” Properties

My introduction to highly-leveraged zero coupon offerings came about 15 years ago when a client approached me with a unique problem. He was selling a strip mall for $11 million. As a very active real estate developer, he had executed numerous cash-out refinances to extract capital for use on other projects. As a result, he owed $10 million on the property. To accomplish a completely tax-deferred 1031 Exchange he would need to invest his $1 million of equity at a 91% Loan-to-Value (LTV) ratio. Even a big developer like himself could not find a lender willing to give him this much leverage

Not completing this 1031 Exchange would pose a unique problem for my investor: He could owe much more in taxes than he would receive in sales proceeds! Since he had owned this property for a long time, his cost basis was $1 million and his 80% improvements value was fully depreciated. This investor had substantial income and other Capital Gains that already put him in the highest tax brackets. If this sale happened today (I’m applying today’s tax rates to this example), his taxes due to the IRS from the sale of this property would be 20% of his $10 million Capital Gain, for $2,000,000. His accumulated depreciation recapture, 80% of $1 million, would be 25% of $800,000 = $200,000. Since he is a California resident, the state will want 13.3% of each – $1,330,000 of his Capital Gain, and $133,000 of his depreciation recapture. Today, the “Obamacare” tax will charge 3.8% ($380,000) additional on his Capital Gain. This all totals $4,043,000 of taxes due from his $11 million sale.

Remember that my investor is paying off $10 million in loans with his sales proceeds. If he weren’t to do an Exchange, his lenders would be paid off first, and escrow would hand him a check for $1 million. Then he’d need to pay his $4,043,000 of taxes the following April. For the privilege of selling his property, he would need to pay the $3,043,000 balance “out of pocket.”

My client therefore decided to defer these taxes (potentially forever) with a 1031 Exchange. I began looking for solutions right away and found an investment company that specialized in the type of deal that I felt may work: A highly-leveraged, zero coupon, partial interest property. This manager had relationships with large institutional lenders and would buy large properties with very high-quality tenants and with long-term leases. The property we selected was a $300 million Amazon Distribution Facility with a $258,000,000 Loan and an 86% LTV.

1031 Refresher Part 2: “Buying Down Your Debt in a 1031 Exchange”

If an investor’s ideal replacement property will have less debt than his 1031 Exchange would require, he can still finish a completely tax-deferred (potentially forever) exchange by adding cash and “Buying Down” his debt requirement. When my investor put his $1,000,000 of equity into this 86% LTV “zero coupon” offering, he was credited for $6,142,857 of loan and bought $7,142,857 of property. This could leave him with “debt boot” of ($10,000,000 – $6,142,857) equaling what the IRS would call a taxable gain of $3,857,143. At the same ratios as calculated above, this would mean a tax bill of $1,542,857.

My client was, however, able to “buy down” this debt for a “discount” since he could also use the leverage to his advantage. He made an additional equity contribution by writing a check for $550,000. At the 86% LTV, he bought $3,928,571 of additional property including the $3,378,571 loan. Therefore his $1,000,000 + $550,000 = $1,550,000 of equity and $6,142,857 + $3,378,571 = $9,521,428 of loan combined to buy $11,070,428 of property. This is greater than the $11 million that he needed to replace and ensured that his 1031 Exchange is fully tax-deferred. (Potentially forever).

Benefits Gained From This Purchase

As a very successful real estate developer, my client understood numbers. Why would he pay over $4 million in taxes when he could defer those taxes (potentially forever) by exchanging his $1 million of sales proceeds and adding an additional $550,000 of cash? Would he rather keep the $2.5 million he saved, or give it to the IRS?

“Combo Exchanges” Using Highly Leveraged and Lower Leveraged Properties Together to Seek Better Cash Flow.

If my client in the example above had needed a more moderate amount of leverage – say 70% – there are ways we can structure his replacement properties to cover all of his debt AND provide good cash flow potential. I have run out of room for my article this month. We will need to expand on this topic more in September.

Can a “Combo Exchange” with a Zero Coupon highly-leveraged offering help your next exchange? Are you having trouble finding enough leverage to meet your 1031 Exchange requirements? Call my office at (877) 313-1868 – we may have some solutions that can help.

Written by Christopher Miller, MBA

Christopher Miller is a Managing Director with Specialized Wealth Management and specializes in tax-advantaged investments including 1031 replacement properties. Chris’ real estate experience includes work in commercial appraisal, in institutional acquisitions for a national real estate syndicator and as an advisor helping clients through over five hundred twenty five 1031 Exchanges. Chris has been featured as an expert in several industry publications and on television and earned an undergraduate business degree and an MBA emphasizing Real Estate Finance from the University of Southern California. Chris began his real estate career in 1998. Call him toll-free at (877) 313 – 1868.

Securities offered through Emerson Equity LLC, member FINRA/SIPC. Emerson Equity LLC and Specialized Wealth Management are not affiliated. All investing involves risk. Always discuss potential investments with your tax and/or investment professional prior to investing.