Deferred Exchanges:  An Additional Perspective

Don’t Let the Tail Wag the Dog!

By Dale C. Eisenman

In a recent issue of the Market Monitor we discussed methods of deferring taxes on the sale of investment real estate.  Putting off paying the taxman is always desirable, right?  No, not if you have to materially compromise your real estate decisions to achieve the tax benefit.  Let’s do a little math to find out just how much that tax benefit is worth before we make our real estate decision. Remember it’s the real estate that makes the money -- Uncle Sam merely takes what you already have or in the very best case, agrees to let you keep it a little longer.

Let’s look at an example to see what the impact would be if you sold your self-storage property and purchased a new property through a tax deferred exchange as opposed to an outright sale and purchase. 

Assume you have decided it’s time to escape the winters and move south, so you have sold your self-storage property in Michigan with thoughts of acquiring a self-storage property in Florida.   The Michigan property was a successful project that you acquired 5 years earlier with the vital statistics in Chart 1. 

Chart 1:  Sold Property

Through the assistance of an Argus broker, you have evaluated a number of Argus listings in Florida and have chosen to pursue a self-storage property with a view of the beach.  The details of proposed purchase are in Chart 2.

Chart 2:  New Property

It’s important to note here, to defer paying taxes on your gain from the Michigan property, you must acquire the new property at a price equal to or greater than that of the relinquished property, incur debt equal to or greater than the debt that you were relieved of when the Michigan property was sold, and reinvest all the net equity into the Florida property.  You may contribute additional cash when acquiring the Florida property to reduce debt without any adverse effect.

The basis of the newly acquired property is the basis of the relinquished (Michigan) property carried forward plus the additional cost of the exchange (Florida) property.  In other words, because you exchanged the Michigan property for the Florida property, you carry over whatever the basis was in the Michigan property plus add to it any additional costs in acquiring the Florida property.  The good news is, because you didn’t have to pay the taxman, your tax “savings” of over $100,000 is now working in your new investment, and will continue to work for you during the entire 5-year holding period.   What difference does this make?  (Let me explain that the detailed analysis was done on a CCIM-developed software package designed for just such purposes, and this analysis is available either from any CCIM Broker or me.)  If we look at the Internal Rate of Return by deferring the payment of taxes, the yield is 19.52% as opposed to the 16.51% you would have earned without deferring the taxes.    A no brainer, right?

Just to be certain, let’s consider the after tax yield of the exchange versus an outright taxable sale followed by a purchase.  After all, what you really want to know is how much money you are going to have in your pocket after taxes.

An outright sale of the Michigan property followed by a separate purchase of the Florida property on an after tax basis generates an 11.83% return.  A tax deferred exchange of the properties has an after tax yield of 12.29%.   Therefore, on an after tax basis, the return is only slightly better utilizing a tax deferred exchange rather than an outright sale and purchase.  The reason that these after tax returns are so close can be found in the title to the article – they are ”tax deferred” exchanges not “tax exempt” exchanges. Proving once again that Uncle Sam gets his due, more or less.

Although not as large of a difference on an after tax basis as on a before tax basis, it is still better and therefore, one should attempt a tax deferred exchange, right?

Chart 3:  Returns

Now we are back to our original question: Is it always beneficial to defer taxes?  It depends.  Could the negative real estate aspects of an exchange that is accomplished under the pressure of 1031 deadlines eat up the small benefit?  You bet.  As we have seen, because the after tax benefit may not be as great as we thought, it is important to make sound real estate decisions and not always allow tax deferral tactics to dominate our actions.  It is important to keep our eye on the ball and to be sure that we don’t let the “tax tail wag our real estate dog”!

It is not the intent of this article to suggest you should or should not enter into a tax deferred exchange, only to point out that you should, with the assistance of professionals, carefully consider the issue.  Every situation is different, and with the help of your Argus broker as a member of your team of professional advisors, you will be able to make an informed decision.   MM

Dale C. Eisenman of Midcoast Properties, Inc. is the Argus Broker Affiliate in North Carolina, South Carolina and Georgia.  He can be reached via e-mail at dale@midcoastproperties.com or via phone at 843-342-7650.