Real Estate Finance: Chapter 14 Investment Financing Strategies

*Sale-Leaseback A creative tool of real estate finance, the sale-leaseback, is used for larger projects.In this situation, the owner of a property sells it to an investor and, at the same time, leases it back.This financing arrangement originated when owners of companies with considerable cash tied up in their real estate wanted to free this capital for more speculative ventures.The lease utilized for this method is usually a fully net lease that extends over a period of time long enough for the investor to recover the initial funds and to make a fair profit on the investment.If the lease is written for 30-years or longer, including renewal options, the IRS tend to consider this a 1031 exchange; the sellers-lessees would not get the rent deduction.In this event, the leasehold would be amortized over the term of the lease.The sale-leaseback approach to real estate finance is applied to commercial properties because rent paid by businesses and professional persons are deductible expenses in the year in which they are incurred.Using this approach, seller-lessees enjoy many benefits.They retain possession of the property while obtaining the full sales price and, in some cases, keep the right to repurchase the property at the end of the lease.The seller-lesses also free capital frozen in equity, maintain an appreciable interest in realty that can be utilized by subleasing or by mortgaging the leasehold, and get a tax deduction for the full amount of the rent, which is equivalent to being able to take depreciation deductions for both the building AND the land.The cash secured from the sale might be utilized for plant expansion, remodeling, or investing in other opportunities.A lease appears as a contingent liability on a firm’s balance sheet, whereas a mortgage or a trust deed is shown as an actual liability and adversely affects the firm’s debt ratio in terms of obtaining future financing.The advantage to the investor-landlord in this type of arrangement include a fair return ON and OF the investment in the form of rental income during the lease term and ownership of a depreciable asset already occupied by a “good” tenant.The investor is buying a guaranteed income stream that can be sheltered through the proper use of allowable deductions.When determining the rent to be paid on the lease, the investor can actually manage the risk by the amount of rent received.The rent for a quality tenant will be lower than the rent for a high-risk tenant.When the lease includes an option for the tenant to repurchase the property at the end of the lease term, it is called a sale-leaseback-buyback.Care must be taken to establish the buyback price for the fair market value at the time of sale.The arrangement is considered a long-term installment loan and any income tax benefits that might have been enjoyed during the term of the lease will be disallowed by the Internal Revenue Service.
*Seller Refinances Prior to Sale When a buyer cannot qualify for a new institutional first trust deed to purchase a property, the seller could refinance the property in order to secure a loan that can be assumed by the buyer.Such a situation might arise if the buyer had a prior bankruptcy or divorce, is newly employed, or is in other circumstances that limit credit ability.At the same time, the seller wishes to acquire as much cash as possible from the sale, so he secures a new loan, requires the buyer to make a cash down payment to the amount of this encumbrance, and completes the sale accordingly.A variation of this technique, and one greatly dependent upon the sincerity and creditworthiness of the buyer, is used when a seller refinances a property and accepts a carryback wraparound contract from the buyer after receiving an acceptable down payment.
*Trading on Seller’s Equity Reversing the previous approach in which the seller refinances prior to the sale, a buyer can secure a sizable cash amount to be paid to a seller by refinancing the subject property instead of assuming the existing loan balance.By arranging the offer accordingly, a buyer might be able to leverage and still develop cash for the seller.Example:Assume a $200,000 property with an existing first loan balance of $125,000 and a seller who is willing to accept a second mortgage for $50,000 and a $25,000 cash down payment, if the buyer assumes the existing loan.An enterprising buyer could offer to secure a new loan for $160,000, based upon the property’s value of $200,000; satisfy the $125,000 existing loan; give the seller the $35,000 cash difference; and execute a $40,000 second deed of trust to the seller, as required. In effect, the seller would be securing the $35,000 cash plus the junior loan for $20,000 as agreed, but the cash down payment would be acquired by capitalizing on the seller’s own equity. Under this arrangement, the seller would be relieved of any liability for the senior debt on the property, which may not have been the case had the buyer assumed the existing loan.The buyer, on the other hand, has leveraged 100%.The weakness in this format, from the seller’s point of view, is that the buyer has no cash invested, and the junior loan is now behind a larger senior loan, increasing the seller’s risk on both counts.These risks can be offset with a higher interest rate on the junior loan, possibly a higher sales price, and a wrap as the junior financing alternative.
*Equity Participation Lenders sometimes enlarge their earning possibilities by participating both as owners and financiers.In addition to the shared appreciation mortgage (SAM), there are several variations of this type of participation financing.
Sale-Buyback Under the variation of the sale-leaseback technique, a lender, usually a life insurance company or a pension fund, agrees to purchase a completed project from the developer and then to sell it right back.The lender attains legal title to the property and profits by including a kicker in the payment to cover a return OF the investment as well as regular interest ON the investment.The developer profits through 100% financing and continued ownership income.Partnership contracts use usually designed to extend 10-years longer than the financing term.The payments made during the financing period would be sufficient to repay the purchase price.The additional 10-years of payments are added compensation to the lender-participator.If a contract runs for 30-years, it might include payments for 20-years sufficient to amortize the sales price, then continue for an additional 10-years at a higher interest rate to satisfy the kicker requirements.
Kicker A bonus paid to a lender as an enticement to make a below-market-interest rate loan.
Splitting Ownership A more common form of lender participation is split-fee financing.In this plan, the lender purchases the land, leases it to the developer, and then finances the improvements to be constructed.The land lease payments are established at an agreed-upon BASE RATE, plus a percentage of the tenant’s rental income above a specified point.Under this arrangement, the lender-investor benefits by receiving a fixed return on the investment plus possible overages while maintaining residual property rights through ownership of the fee.The developer has the advantage of high leverage and participatory profits.
Split-Fee Financing Type of equity participation in which the lender purchases the land, leases it to the developer, and finances the leasehold improvements in return for a basic rental plus a percentage of the profits.
Joint Ventures The most common form of equity participation is the joint venture, in which the lender puts 100% of the funds needed for a development UP FRONT in exchange for the expertise and time of the developer.The lender then becomes an investor in full partnership with the developer.Some joint venture partnerships are expanded to include the landowner, the developer, the construction company, and the financier.The developer then supervises the entire project from its inception until it is completely rented, and sometimes even beyond as a permanent manager.
*Tax-Deferred Financing One of the most effective tools available to all property owners for acquiring additional funds while postponing any tax impact is to refinance a property that has developed an increased equity by an increase in value, and the amortization of its existing loan or both.Refinancing involves the securing of a new loan to replace an old loan.Logically, the new loan should be sufficient not only to satisfy the balance of the existing loan but also to pay all of the placement costs involved, as well as generate new cash for the borrower to use for additional investments.Any money acquired by refinancing is NOT subject to tax, even if these funds exceed the original purchase price of th specific property.This money is considered borrowed money and, as such, is not taxable.In this regard, relevant to the discussion of income tax impacts is the distinction between two types of capital gains income.Realized capital gain is the difference between the total consideration received and the adjusted book basis of the property transferred.Recognized capital gain is that portion of the realized gain that is subject to income tax in the year received.In the case of refinancing, and appreciation or “profit” in the property received from the proceeds of the new loan is not considered realized and is not subject to income taxes until the property is sold.Owners may periodically refinance their properties during their lifetimes, generating tax-deferred dollars for reinvestment.At the time of death, the properties would receive a step-up in basis to fair market value and could be distributed to the heirs free of potential income tax on any appreciation to time of death.Most refinancing decisions will be governed by balancing the possible gains to be made against the known costs to be incurred.To refinance an existing 6% interest loan with one at 8% interest is not practical unless the borrower can earn more than 8% on a reinvestment of the new monies secured.The best alternative is to leave the existing financial arrangement alone.A refinancing decision should be based on the alternative investment opportunities or a measurement of opportunity costs.These measurements, like so many other in real estate finance, including subjective as well as objective inputs.The most emotional and subjective involvement in real estate finance transpires at the home ownership level.The security of owning a home free and clear of debt is a goal that has been handed down from generation to generation and one to be sought with thrift and enterprise, even at great sacrifice.For those persons whose home will be the only substantial investment made in their lifetimes, this philosophy is comfortable and correct.For those persons who seek to acquire a larger real estate portfolio, free and clear ownership may not be a practical course to follow.
Refinance Replacing an existing mortgage; usually to gain a more favorable rate.
Capital Gains Income earned from the sale of investments where the net sales price exceeds the adjusted book basis.
Realized Capital Gain Investment profits not subject to income tax, e.g., profits from refinancing, exchanges, and installment sales.
Adjusted Book Basis Purchase price of a property plus any capital improvements minus accrued depreciation to the date of the sale.
Recognized Capital Gain Profits from the sale of investments and subject to income tax; derived by subtracting the adjusted book basis from the net proceeds of the sale.
Pyramiding Through Refinancing Real estate ownership can provide a means for accumulating great wealth.In order to establish a valuable investment portfolio, one must work hard, take carefully calculated risks, and apply appropriate leverage.One way to acquire a substantial amount of real estate is to periodically refinance those properties already owned and then use the proceeds to purchase new properties.This procedure is terms pyramiding.Unlike pyramiding through SELLING, where an investor will purchase one property by conventional methods, improve it for resale at a higher price, and then purchase two properties with the gains from the sale, pyramiding through REFINANCING is based upon RETAINING all properties acquired.By not selling the properties, the investor is constantly increasing the refinancing base while capital gains taxes are postponed.Pyramiding through refinancing begins with the purchase of a property.If more than one property can be purchased to start the plan, the refinancing base will be enhanced at the outset.The type of property to be purchased should be improved income property that has the ability to generate cash flow.To approach pyramiding from a theoretical point of view, the investor anticipates that the original property will increase in value over time.Simultaneously, the loan payments being made will reduce the balance owed and build equity for the investor.Assuming a 5-year refinancing cycle, it could be possible to secure a new loan every 5-years in an amount sufficient to satisfy the balance of the old loan, pay the loan acquisition costs, and return at least enough cash to make a down payment on the next purchase.As the new loan is for a larger amount than the old one, higher payments will be required, perhaps at a higher rate of interest.The passage of 5-years should also provide the owner with an opportunity to raise rents commensurate with the property’s increasing value and inflationary market trends in order to satisfy at least the breakeven requirements.It is in the best interests of the pyramid investor to purchase newer properties in stable or growing areas.An older property in a declining neighborhood would make a poor investment.Rents and values f such buildings might actually fall and destroy the refinancing cycle.After refinancing the initial property, the pyramider will then purchase an additional rental unit, either residential or commercial, with the net proceeds from the refinancing.The investor now owns 2 properties from the original investment.Theoretically, by continuing this sequence, the pyramider should be able to double holdings every 5-years.The 2 properties would increase to 4 at the end of 10-years, 8 in 15-years, and 16 in 20-years.There would be a substantial amount outstanding in loan again these properties, but if an estate of this size was sufficient for the investor, the rents could then be turned inward to satisfy the various balances owed and end the pyramiding process.With the appropriate application of allowable deductions, most, if not all, of the net income earned during the years of ownership can be sheltered, as capital gains taxes are delayed the refinancing process.The estate can then be left to the investor’s heirs, without the investor ever having paid capital gains tax on any profits derived from ownership of these properties.A deceased person’s property is appraised to determine its value for estate tax purpose.The heirs take title to the property, its book value being the appraised value established as of the date of death.The old book value, which reflects the deceased owner’s acquisition costs, is eliminated.If the heirs choose to sell the property at this point, the capital gains tax would be based upon any profits secured from the difference between the sale price and the NEW BOOK VALUE, which reflects current market value.If the heirs sell the inherited property at a price equal to its probated estate value, NO CAPITAL GAINS WILL BE PAID even though the property is sold for many times more than what the deceased paid for it.Just as important as this savings is the opportunity for the heirs to develop a larger estate.Should they decide to keep the inherited property, the heirs can refinance it, secure new tax-free cash for reinvestments, and shelter much of their earnings through allowable deductions based upon the new, and higher, book value of the inherited property.Although the pyramiding plan is theoretical, it is completely workable if adjustments are made for those problems that will inevitably arise.Depending upon money market conditions, a 5-year refinancing cycle may not always be practical.A poor investment choice may be made along the acquisition route or the economy can decline to a point where there will be no increase in property value for an extended time period.These conditions, plus the risks and work involved, may exceed the rewards, but this is a decision each investor must make individually.
Pyramiding Method of acquiring additional properties through refinancing existing mortgages.
Distribution to Heirs The ultimate capital gains tax shelter is to maintain ownership of investment property until death.At death, the property is appraised for estate tax purposes, and the deceased’s heirs acquire title with the new basis of the inherited property at the fair market value established at the time of death.With the appropriate application of tax-free gift giving, taxes on the decedent’s estate can be avoided.
Federal Estate Tax The 2013 exemption from federal estate taxes is $5 million per person.To pay estate taxes, then, a deceased’s estate would have to be evaluated at more than $10 million net if owned as community property of jointly with a spouse.The gross value of the entire estate is estimated, debts against the estate, as well as all probate costs deducted, and the balance (or one-half if owned jointly or as community property) must exceed $5 million before it is subject to federal estate taxes.It is possible that Congress will adopt law changes to Federal Estate Taxes.Consult with your tax professional.
Estate Taxes A tax imposed by federal and state agencies on the net value of a deceased’s estate.
California Inheritance Tax Both the California inheritance tax law and the gift tax law were repealed as of June 8, 1982.Upon repeal of these two tax laws, the state enacted a California estate tax that takes advantage of a provision in federal law, which allows the estate to take credit for California estate taxes paid against any federal estate taxes due.The state tax is limited to the maximum the federal government allows as a credit against any federal estate taxes due.
With Gift Tax With proper planning, investors may be able to distribute their entire estates by utilizing tax-free gifts to avoid estate taxes.The 2013 law provides gift exemptions of up to $14,000 for each donor per donee per year.Thus, a husband and wife can gift $28,000 tax free each year to each heir.Gifts in excess of the exemptions are subject to tax at the federal level and at the state level.
Tax-Free Gifts Gifts free from any federal gift tax imposition.

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