1. Work with a competent tax professional:

1031 exchanges can be complicated, and thus, it is important to discuss your tax goals with a tax professional before entering into an exchange agreement. Your tax advisor can provide you with the advice you need to determine if an exchange is right for the transaction, and can help you structure the exchange so that your tax goals are satisfied. The qualified intermediary cannot provide legal advice about the exchange, nor can they structure the exchange for the taxpayer.

2. Understand the exchange rules:

When performing an exchange, there are many rules that come into play. The taxpayer must abide by these rules for their exchange to qualify for non-recognition treatment under IRC § 1031. Here’s a concise breakdown of the basic rules:

1. Use a Qualified Intermediary: The taxpayer cannot receive or control funds during the exchange period.

2. Exchange Like-Kind Property: The relinquished property and the acquisition property must be like-kind when exchanging.

3. Exchange Equal to or Up: The taxpayer must acquire replacement property that is equal to or greater than the net value of the relinquished property. In addition, the taxpayer must reinvest all net equity from the relinquished property, or a taxable gain will occur.

4. Identify Replacement Property in 45 Days: The replacement property for the exchange must be identified in writing no later than 45 days from the date of sale.

5. Acquire Replacement Property as the Same Taxpayer: When completing an exchange the taxpayer who relinquishes property must be the same taxpayer who acquires property.

6. Acquire Replacement Property within 180 Days Or Before Filing Your Tax Return: The taxpayer has 180 days from the date of sale or the due date of their tax return (for the year of the sale) to complete their exchange. Some taxpayers may choose to file a tax extension to extend their tax filing due date, so that they have the full 180 day period to complete their exchange transaction.

3. Ask Questions:

As an exchange coordinator for a qualified intermediary (QI), I am amazed at the hesitance demonstrated by some taxpayers to ask questions. Taxpayers may make assumptions about exchanging, or “have heard from a friend” what is involved in the completion a successful exchange. However, the reliance upon assumptions and hearsay can be disastrous for the taxpayer!

So what’s the remedy? Find a qualified team of professionals to help you distinguish the facts from the misguided myths! This team may consist of a tax professional (a CPA and/or tax attorney), a real estate broker, and the qualified intermediary. Rely on these parties to answer your questions.

Looking for a good qualified intermediary? Understand that the qualified intermediary plays a very important role in the exchange process. Throughout the exchange, the QI should be available to answer questions and provide guidance to the taxpayer in a timely fashion. In addition, they should remind the taxpayer of their exchange deadlines. A local QI can be available to meet with the taxpayer to accept identification letters in-person, and may offer office hours to consult with those involved in the exchange transaction.

When searching for a QI, ask your tax professionals and brokers for a recommendation. Before you select a QI, ask the staff working for the QI about their experience and education, and verify that the QI maintains both fidelity and errors and omission bonds. In addition, since this QI is holding your funds in their account, be sure to do some research about how funds are held by the QI during the exchange period! A good QI should have no problems providing this information to the taxpayer that is interviewing them for accommodation services!

Written by: Sarah B. Johnson, Exchange Coordinator
Certified Exchange Specialist®
Vice-President, Cascade Exchange Services, Inc.

Each investor will have a different reason for participating in an exchange of property. Here are some examples of why investors exchange:

- Cash Flow: Exchange bare land which produces no income for improved property that can create cash flow

- Business Use: Exchange out of a property for another property that can used to accommodate your business

- Location: Exchange property out of area for property in a closer location, or exchange for property located in a better market

- Appreciation: Exchange to a location where properties appreciate faster or exchange one type of property for another that appreciates more quickly

- Depreciation: Exchange from a fully depreciated property into a higher valued property that can be depreciated further

- Easier Sale: Exchange for property that is easy to sell (at a later date, of course!)

- Diversification: Exchange a large property to acquire numerous replacement properties, or exchange one type of property to acquire many different types of property

- Defer the Recapture of Depreciation: Exchange to defer the recapture of depreciation. For sales involving improved property, depreciation is currently recaptured at the rate of 25%!

- Capital Gains Deferral: Exchange to defer capital gains tax! By performing a 1031 exchange, a taxpayer is able to defer their capital gains taxes, and thus, has more cash available to acquire other, like-kind investment property!

Did you know that it is possible to sell a property, have no proceeds, and still owe capital gains tax? Capital gain is not the profit or equity from a sale; it is computed by determining the difference between the taxpayer’s sales price and the adjusted cost basis of their property.

Talk to a tax professional regarding your potential tax liability before completing a sale. A 1031 exchange may be the tool to help you reach your investment goals!

Written by: Sarah B. Johnson, Exchange Coordinator
Certified Exchange Specialist®
Vice-President, Cascade Exchange Services, Inc.

Don’t misinterpret like-kind property

When completing a successful exchange, a taxpayer must relinquish and acquire like-kind property. However, many taxpayers misinterpret like-kind property. All too often I hear, “If I exchange a duplex, don’t I have to buy a duplex?” I always respond by clearly defining like-kind property.

Like-kind property refers to the intended use of the real property, not the type of real property, as investors often believe. Provided that the property is initially acquired and held for either business or investment purposes, it can qualify as a suitable replacement property under IRC Section 1031. Like-kind real property exchanges may, for example, include any of the following: bare land for a rental house, duplex for a fourplex, retail center for an apartment complex or an office building. And yes, you can also exchange from residential to commercial property (and vice-versa)!

Don’t overlook the key rules when structuring your exchange

Many taxpayers may attempt to complete an exchange by abiding by some, but not all of the basic structuring rules. To maximize tax deferral when completing a tax deferred exchange, it is pertinent that the taxpayer exchanges equal or up in both net value and net equity. Some taxpayers may attempt to simply reinvest their equity, but do not regard the equal or up requirement for value in the replacement property. The erred philosophy: “As long as I reinvest all of the proceeds I don’t pay taxes.” Although this argument may be true in some circumstances (some taxpayers have no debt on the relinquished property and no boot recognized in the transaction), this is a dangerous approach when structuring your exchange.

When completing any exchange transaction, the taxpayer should work closely with their tax professional to discuss their anticipated tax outcome and to structure the exchange. For example, some taxpayers will intentionally structure their exchange to defer some, but not all of their tax liability. A partially deferred exchange can help a taxpayer accomplish more than one of their goals, but is only going to please the taxpayer if the recognized gain is planned!

Don’t start looking for replacement properties late into the identification period

A taxpayer has 45 days from the date of the closing on the relinquished property to identify their replacement property. To identify, the taxpayer must sign a letter that provides an unambiguous description of the replacement property being acquired. As you may imagine, this strict timeline can be one of the most challenging aspects of performing an exchange. Unfortunately, once the 45 day identification period has passed a taxpayer is not able to switch their previously identified property for another. In addition, the taxpayer cannot add replacement property after the 45 day period!

A prominent real estate broker and exchange specialist sums up his strategy; “the best theory is to complete the exchange in the 45 day period. Once the 45 day identification period expires, the taxpayer looses their flexibility and is at the mercy of others!” So… start looking early in the exchange period. Consider hiring a broker who knows how to help you meet your exchange goals, and one who understands the significance of this crucial 45 day timeline! If you start looking late in the period, you may identify something other than what you really want or need!

Don’t control the exchange funds during the exchange period

I have been in the exchange industry since 2003, and have assisted taxpayers with the closing of thousands of exchange transactions. The role of the facilitator (aka: qualified intermediary, QI, exchange intermediary, accommodator) is to assist the taxpayer with exchange questions, to prepare the required exchange documents, and most importantly, to hold the exchange funds outside of the control of the taxpayer.

In a 1031 exchange the exchangor (the person exchanging) cannot have actual or constructive receipt of exchange funds. They cannot receive funds, borrow against funds or direct their use. During the exchange period the exchange proceeds remain in an exchange value account where they are outside of the exchangor’s control. Once funds are deposited into the exchange value account they remain there until the taxpayer acquires replacement property or terminates the exchange agreement. A taxpayer cannot ask for “draws” on the funds for personal use, and cannot hold them in an account that they control. In addition, the facilitator cannot be an agent or nominee of the exchangor.

Don’t decide to exchange after you sell

If a taxpayer would like to participate in a 1031 exchange transaction, they must set-up the exchange before the relinquished property is conveyed to the buyer. The exchangor must execute an exchange agreement with the exchange facilitator, and sale proceeds must be delivered to this facilitator and not the taxpayer.

If a taxpayer conveys title to a buyer, and then decides they’d like to exchange, it is simply too late to reverse this process! This is not an exchange, but is recognized as a sale transaction for the taxpayer. The lesson here is to plan ahead; for the taxpayer to determine if a sale or an exchange is the right fit for the transaction, before it closes.

Do not do an exchange if you are not holding for investment purposes

1031 exchanges allow a taxpayer to defer the recognition of gain on a relinquished property, provided that investment property is exchanged solely for like kind property that is held for the same use. Investment property is not property held for personal use, nor it is property that is acquired for resale purposes. As a result, the acquisition of a house for flipping purposes or for use as a second home would not qualify for exchange treatment.

Is it a second home or investment property? The Revenue Procedure 2008-16 provides a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031. It states that a dwelling unit qualifies as relinquished/replacement property in an exchange if it is owned by the taxpayer for at least 24 months immediately before/after the exchange. In addition, during this period the taxpayer must rent the property at a fair rental for 14 days or more and the personal use of the property cannot exceed the greater of 14 days or 10% of the number of days during the year that the property is rented at a fair rental.

Written by: Sarah B. Johnson, Exchange Coordinator
Certified Exchange Specialist®
Vice-President, Cascade Exchange Services, Inc.

PART ONE: THE BASICS

Cap Rates – A Hot Topic: For apartment investors and apartment brokers, the subject of cap rates is critical right now.

Why Now: Cap rates are starting to change at a pretty good rate in  response to the current recession and changes in apartment financing interest rates.

First – Some Background Information

What does a “Cap Rate” tell you? The cap rate is one of the best indicators of investment productivity for an income producing rental property.

The Technique Name: The term “Cap Rate” is the main ingredient of the mathematical formula of “Capitalization Rate of Net Operating Income”.

How is the Cap Rate Used?

Note from Reader to Self: “Is this stuff worth learning?                                 Restated “What is in it for me, if I learn this stuff?”

Proper Answer: If you don’t learn about it and how to use it properly, then you had better hire someone like Bob Nelson, CCIM, then hang your financial well-being on his ability to “think properly for you”.

Restated: Learn what the prudent investor must know to protect and advance your own position.

While it certainly would be wise to hire “The Guru”, it would also be equally wise to understand what guides his thinking, in case he gets run over by a bus!!

CAP RATE APPLICATIONS

The cap rate has a number of very valuable uses, depending upon its user.

1. Owners: An owner could use the cap rate to determine the productivity of the various properties owned.
   1. Rule: The higher the cap rate, the more productive is the property’s capacity to generate cash flow relative to the value that the owner assigns to that property. .
   2. b. Rule: The higher the cap rate, the higher the property’s return
   3. c. Rule: Use the cap rate and the current available interest rate to forecast the potential benefit of increased yield that would result from refinancing the property today.
   4. d. Rule: When it comes to portfolio adjustment time, use the cap rate to identify the “runt of the litter” (worst performer), then exchange that one into a more productive property.

1. 2. Buyers: A buyer can use the cap rate to determine the relative appeal of several properties being considered.
   1. a. Rule: All other features considered equal, chase the property that offers the highest cap rate, and kick the low performer to the curb.
   2. b. Rule: If the indicated cap rate at the asking price is too low, then offer a lower price.
      1. i. Force the offer price to generate the cap rate that is your minimum purchasing criteria for investments of comparable risk, similar location, and similar physical characteristic.
      2. ii. This may not work for the seller, but you can make wise decisions using the cap rate selection criteria.

1. 3. Sellers: A seller can forecast with a high degree of accuracy what a reasonable asking price should be for each property that they own.
   1. a. Rule: Apply the “current” market generated cap rate to the NOI of each property to forecast how a qualified buyer would probably respond given a particular asking price.
   2. b. Rule: Use the cap rate and the current available interest rate to forecast the potential benefit of an increased yield that would result from refinancing the property today.

WHAT IS NET OPERATING INCOME?

The Net Operating Income (“NOI”) is the annual cash flow that you would receive if you own the property free and clear of debt and before paying your income taxs on the received cash flow (“cash flow before debt service and before person income taxes”).

The “NOI” Formula  -   For Apartments:

Scheduled Gross Rental Income (at current rental rates)

-   Vacancy and Credit Loss loss from vacant units and no-pay tenants

Effective Gross Rental Income

+   Other Dependable Income such as:

Tenant Deposits (while not “income”, it offsets expenses later)

Sub-metered Utility Income (if units are sub-metered)

Vending Income (laundry income, etc.)

Effective Annual Income

-     Fixed Expenses: (expenses that do not vary with occupancy)

Property Taxes

Property Insurance

-          Variable Expenses: (expenses that vary with occupancy)

Property Management

Advertising

Legal and Accounting

Utilities (provided by the owner)

Trash Removal

Maintenance and Repairs

Supplies

Grounds Maintenance

Reserve For Replacement of Short Lived Assets

Net Operating Income  “NOI”

Again, Net Operating Income “NOI” is the amount of annual cash flow that you would receive if you:

1. 1. receive all of the income that is reasonably available from a well managed property;
2. 2. own the property free and clear of debt; and,
3. 3. prior to paying income tax on incomes received from the property

If you think about it, that is a very sensible way to measure the true productivity of the property.

1. 1. The mortgage payment is not a function of property productivity.

It is a function of property ownership.

Restated: the property doesn’t come with a mortgage. I may have to put a large mortgage on the property in order to own it. While you could own the property free and clear of debt. For both of us, the property will produce the same NOI.

• A very large portion of that NOI will have to be used to service my large mortgage loan.
• You get to keep what I paid as mortgage payment as your cash flow since you have no mortgage.

What Is NOT Included In NOI?

As previously stated, the mortgage payment and your personal income taxes are not considered in the calculation of  Net Operating Income “NOI”.

There are other expenditures that would be incurred periodically, but those expenditures are not part of NOI.

Example: A Capital Improvement – those improvements that not be recurring annual expenditures that would extend the useful life of the property.

Example:  New Roof. While a new roof is necessary to protect the asset and its ability to attract and retain tenants, the cost of the new roof would not be included in the calculation of NOI.

Why: The cost of the new roof is not a recurring annual expense. You don’t pay to put a new roof on every year… unless the property is located in Tornado Ally…

CALCULATING THE CAP RATE

The mathematic relationship that calculates a “Cap Rate” is demonstrated below in a circle diagram.

Cover the component you wish to calculate, and the formula for its calculation is demonstrated by the circle diagram

NOI  =   Net Operating Income (of a comparable property)

R    =   Cap Rate (derived from the market)

IV   =   Investment Value (or Sale Price of a comparable property)

USE: To calculate Cap Rate “R”, then cover the “R” and it shows you that you take the NOI of the property and divide it by its Sale Price.

Typical and Common Cap Rates in the Pacific Northwest:

Rental Houses:                4% to 5% cap rate

Duplexes                         5% to 6% cap rate

Larger Apartments           7% to 9% varies with location and condition

R =  NOI / Value It is a market derived percentage that reflects what a specific type of highly similar properties are selling for relative to the NOI that those properties generated at time of sale

PART TWO:  BEYOND THE BASICS

Assuming that you have a reasonable understanding of Net Operating Income “NOI” and Cap Rate “R” let’s consider what such knowledge can do for an informed investor

FOR APARTMENT COMPLEXES

IN THE

PACIFIC NORTHWEST

CAP RATES HAVE INCREASED RECENTLY

Starting about mid-January, 2010, cap rates for apartment complexes have increased noticeably.

2009 to 2010:

6.5% on attractive well located apartment complexes

6.75% to 7.0% for older but well located complexes

7.0% to 7.5% for older “so-so” maintained complexes

Mid-January 2010 to present mid-March 2010:

7.0% on attractive well located apartment complexes

7.25% to 7.75% for older but well located complexes

8.0% to 8.5% for older “so-so” maintained complexes

Preliminary Market Observation: Cap Rates of mid-sized apartment complexes have risen about ½% from, early January 2010 through mid-March 2010.

WHAT CAUSES CAP RATES TO CHANGE?

1. 1. Availability of qualified buyers willing to purchase
   1. a. In my opinion, there are more cash-heavy buyers looking to purchase in mid-March 2010 than existed in September, 2010.
   2. b. I sense that cash heavy investors have been sitting on the side-lines “waiting for the bottom of the income property market” in the current recessive market.
   3. c. They are tired of receiving 1.5% on their savings accounts, and are attracted by the 8% yields that could be had on a free and clear apartment complex.

1. 2. Some fairly desperate sellers needing to sell
   1. a. I sense that there are a number of apartment complex owners that have felt the bite of the recession, and have decided that they need to sell one or more of their portfolio assets in order to develop liquidity to protect the balance of their net worth
   2. b. More desperate sellers will accept lower prices, thus causing a higher cap rate for the property that they are selling.
   3. c. As the cash heavy buyers see increasing cap rates, those rates on other competing complexes will be applied to all other properties on the open market.
   4. d. A limited feeding frenzy could develop as investors move to acquire attractively price apartment complexes with low fixed interest rates. It simply makes sense to buy now. The moon and stars are in alignment for the perfect buying season.

1. 3. Lenders that typically finance apartment complexes are become more and more conservative in their lending practices.
   1. a. They will instruct commercial appraisers to be more conservative with their appraisal reports. They will have more conservative estimated of the property’s NOI, and the “Overall Rate of Return” (effectively the “Cap Rate” used by the appraiser) will be increased with each increasing market cap rate observed in the market.
   2. b. The lender will use a more conservative Debt Coverage Ratio “DCR” when determining the amount of money that will be loaned relative to the property’s capacity to service the debt.

PROBABLY FUTURE ACTIONS

Nelsonian Wild-Eyed Philosophizing:

1. 1. Concerning Cap Rates: Cap rates for apartment complexes will increase slightly, but will stabilize until such time when interest rates increase significantly. Then, cap rates will parallel the increase in interest rates.

1. 2. Concerning Investor Greed:

1. a. Investors who get too greedy (insist on using too high of a cap rate) will be snubbed by apartment complex owners who are not desperate to sell.
2. b. Those investors who are more moderate in “throwing their purchasing weight around”  (e.g.  will accept “market rate” cap rates) will be in an excellent position to acquire the BEST ASSET TYPE WITH THE HIGHEST OVERALL PROBABILITY OF SURVIVING THE CURRENT RECESSION
3. c. Restated: The greedy will become the needy

[1,833 words to here]

STAY TUNED FOR MORE EDITORIAL COMMENT,

AS I OBSERVE CHANGE IN OUR MARKET PLACE

Thank you for your attention

Bob Nelson, CCIM

Real Estate Investment Broker

“The 1031 Guru”

Pacwest Real Estate Investments, LLC

711 Country Club Road

and

3130 Beech Street

Eugene, Oregon 97405-4344

(541) 485-8100

bob@1031guru.co

www.1031guru.com

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Choosing a Realtor part 1

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Choosing a Realtor part 2

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Choosing a Realtor part 3

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Short sales part 1

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Short sales part 2

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Negotiating part 1

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Negotiating part 2

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Negotiating part 3

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Bottom of the Market

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Revised Lending

Accountants and tax advisors preparing tax returns for the following types of taxpayers should look at the recent tax incentives below and consider utilizing these incentives on the 2009 tax return or amending prior year returns to claim these incentives:

Multi-Family Residential Developers & Homebuilders

IRC 45L – Allows for a $2,000 tax credit per qualified apartment, condominium unit, or single family home. For example, a 50 unit apartment can be eligible for $100,000 of Federal Tax Credits.

Commercial Developers

IRC 179D – Allows taxpayers to claim a deduction of $1.80 per square foot for qualified buildings constructed. For example, if the taxpayer builds an eligible 100,000 SF building the taxpayer is entitled to $180,000 of Federal tax deductions.

Any Taxpayer Making Substantial Improvements To An Existing Building

IRC 48 – Allows for a tax credit of up to 30% of the cost for qualified building expenditures and special treatment on the remaining depreciable basis. Consult with a tax advisor as tax credits that cannot be used by the taxpayer may be able to be monetized to help taxpayer obtain cash.