Failing fast, failing forward, and learning from others failures has been critical to my growth as a business owner and real estate investor. This is part of my series on Failing Forward, and I hope you walk away with some great strategies (or pitfalls to avoid).
If you followed the first parts of this series (Links to PART 1, PART 2, PART 3, PART 4), you heard how we resolved multiple issues with a suburban shopping center. This story takes on a different topic: Multi-Family Due Diligence.
1031 Exchanges – What Happens When You are Upside Down?
Another unusual transaction we came across in 2015 was a Buyer Client who hired us to identify a 1031 Exchange Purchase to relocate their operating business. It so happened that this business, which he had owned and operated for over 30 years, was going through a challenging cycle in the market. I was not involved in the sale transaction of his current building, and as a result was not aware of its basis, loan-to-value, or the logistics of its closing date. In our initial conversation, he indicated that he would need to 1031 Exchange about $200K. However, as we dug into the questions surrounding his budget ($1M) and what type of loan he would be obtaining, it turned out that the situation was quite dire. Here are the highlights:
- Sale: $2M
- Loan Payoff: $1.8M
- Cash at Closing: $200K
- Basis: $0
It turns out that he would owe close to $900K in capital gains tax if he did not execute a 1031, and some portion thereof if the acquisition price was less than $2M. Further, he only had $200K to put towards another purchase. In addition, obtaining financing from a lender with his business on the fringe was an obstacle as well.
In the end, we were able to get him into a $875K Purchase which offset about half of his tax obligation, the rest he had to set up a payment plan with the IRS over a 3-5 year period. Hindsight is 20/20, however, there were several opportunities to positively impact this situation on the front end of the transaction:
1. Timing: If you are selling in a market where it is difficult to identify a 1031, structure options to extend closing on behalf of the Seller. I often use 2 thirty day options to extend my contracts.
2. Sale Structure: In this case, the Seller gave the Buyer in his initial transaction a credit at closing for some of the deferred maintenance items (including the roof). It would have been much more advantageous to offer a reduced sale price.
3. Purchase Structure: If there was additional time, given that this was a down economy, we may have been able to identify a purchase opportunity where Seller Financing was an option up to 90% LTV. Especially in a larger building that had the opportunity to include co-tenants. That would have allowed a larger purchase to offset the entire tax consequence.