Recently, I’ve had several conversations with real estate investors who own Tenants-In-Common (TIC) replacement properties that are going to be sold in the near future. In each case, sometime during the past decade they used part of their 1031 exchange funds to purchase TIC properties that are now being sold because mortgage is coming due. Unfortunately, several of these investors will receive substantially less in sale proceeds than they originally invested due to poor property performance. Needless to say, these folks aren’t real happy.
Many times these investors call Realized to ask a general procedural or tax questions about the sale of their TIC investments, which of course we’re happy to answer. We also always advise the investor to speak with an outside CPA. If it’s a tax question, I find the best place to start is by putting their tax information in our 1031 Exchange Calculator. Too often, the results are bad news. Even though they were losing money on an investment, they may be looking at a stiff capital gains tax bill.
For illustration, here’s one scenario. About ten years ago, a couple sold their debt-free apartment building for $485,000 and were facing a capital gain of $200,000. They used a 1031 exchange to defer their capital gains by investing $485,000 in a TIC investment. When they invested, the TIC had a 70% loan-to-value mortgage and their Adjusted Tax Basis looked something like this:
| Cash Equity Invested: | $ 485,000 |
| Allocated Mortgage Debt (70%): | $1,132,000 |
| Total Fair Market Value (FMV) | $1,617,000 |
| Less: Deferred Gain | ($ 200,000) |
| Adjusted Tax Basis | $1,417,000 |
Although the apartment building they sold was debt-free, they chose to reinvest in a TIC property that had a debt. Why? Because, the $1,132,000 in additional debt increased their tax basis from $200,000 to $1,132,000 and allowed them to use depreciation to shelter most, if not all of the income they received from the investment. During the last 10 years, they have deducted a total of $500,000 in depreciation, meaning their Adjusted Tax Basis today is $917,000 ($1,417,000 - $500,000).
Because the property is performing poorly, it is being sold at a loss meaning the couple will receive less than they invested. In this example $212,000 ($485,000 - $273,000).
| Sales Price of Interest in TIC | $ 1,200,000 |
| Less: Share of Mortgage Balance | ($ 912,000) |
| Less: Closing Costs | ($ 15,000) |
| Net Cash Proceeds to Couple | $ 273,000 |
The couple’s tax situation is as follows:
| Sales Price of Interest in TIC | $1,200,000 |
| Less: Closing Costs | ($ 15,000) |
| Less: Adjusted Tax Basis | ($ 917,000) |
| Realized Gain | $ 268,000 |
Notice that even though the are losing money on the investment, they still have a taxable gain of $268,000. In this case, the capital gains and depreciation recapture taxes on the gain are estimated to be $113,000. Like some investors, they don’t want to pay $113,000 in tax and quickly came to the conclusion that they should do another 1031 exchange. This makes sense, they can do a 1031 exchange when coming out of a TIC or Delaware Statutory Trust (DST).
I explained to the couple that in order to defer the entire gain they would need to reinvest in a property that:
- Has a price of at least $1,200,000 (the amount their TIC interest is being sold for), and;
- Has a mortgage of at least $912,000 (their share of mortgage balance as sale).
Here’s the crux of their problem - they would need to obtain a mortgage with a loan-to-value of 76% ($912,000/$1,200,000), which may be difficult to achieve. If the mortgage on the property they buy is less than $912,000, they will be subject to tax on any reduction in debt, or what is known as mortgage “boot.”
Based on the limited information and conversion, it appeared that the couple has two options for deferring $113,000 in taxes, neither of which are palatable.
- Invest in a highly leveraged investment.
- Use less debt by investing additional cash (more than $273,000) in the property they buy.
Understandably, this was a hard pill to swallow for the couple, particularly since they assumed when they called to ask a simple question, they were not going to owe any taxes. Surprised, we offer to help them sort through their situation. They say yes, and we ask for the name of their tax professional that prepares their tax returns. If they don’t have a one, we suggested that they engage a Certified Public Accountant (CPA) immediately to counsel them.
Next Realized goes through their tax returns for the past ten years. In this particular situation we find that their TIC had generated $215,000 in taxable losses during this period. These passive losses were ‘suspended’, meaning that the couple has not been able to use them in prior years. This gets nerds like us excited because it means when the TIC is sold, these suspended passive losses will be freed up and can be applied against the capital gain. Viola, by applying these losses their $268,000 gain decreased to $53,000 and their estimate capital gains taxes owed dropped from $113,000 to only $22,000.
In the next conversation with the couple, they report that this is good news, but they are still interested in doing an exchange to defer paying $22,000 in taxes. We explained they would still need a substantial amount of debt or to kick in additional cash. Perhaps a better option is get off the 1031 exchange “marry-go-round” and pay the $22,000.
Armed with more complete information, they discuss their options with their CPA and financial advisors and decided not to do an exchange. They are going to go ahead and pay their taxes and avoid having to find another property within 45 days. This decision gives them the option to diversify into more liquid (non-real estate) investments. Or, if they do choose to go back into real estate, they now have time to find the right property, which can purchased with a moderate level debt or no debt at all. In addition, if they do buy another investment property, they will start fresh with a new tax basis that allows them to use depreciation to shelter income.
Lessons learned:
- Investors should look at their entire tax when considering a 1031 exchange, which means all the way to the original exchange;
- Consult a tax professional, the tax code is complicated;
- Be mindful of the amount of debt on real estate investments, including passive investments like TICs and DSTs. Decisions today have implications in the future;
- For many investors, the best option is NOT doing a 1031 exchange;
- Fully-Informed investors make better investments;
- Complete information is key when deciding whether or not to do a 1031 exchange.
