Brooke’s Note: Elizabeth writes about investors with high class problems and how they can be helped. See: Five reasons for RIAs to think more like Goldman Sachs about businesses owned by clients. In other words she offers intelligence on how RIAs can land and keep the most prized clients. In this piece she dissects the circumstances faced by one 82 year-old investor whose real estate was severely depressed in value from its highs but highly appreciated from its cost basis — a lose-lose situation for a liquidity event? Read on.

Do you have clients who are stuck owning commercial real estate who would sell their properties and re-invest the proceeds into other asset classes if it weren’t for the tax bite?

The clients of wealth managers and financial advisors own vast amounts of commercial real estate. In many cases it encompasses a significant portion of the assets of a client’s privately owned business, and is frequently held as a standalone investment. In many instances commercial real estate comprises a significant portion of the client’s net worth.

Typically, the real estate has been held a long time, has appreciated significantly and has a low cost basis for tax purposes. Over the next decade, baby boomers will need to sell or monetize trillions of dollars of their commercial real estate to fund their retirement needs. This presents a significant opportunity for financial advisors to capture additional AUM.

In addition, over the past few years the owners of commercial real estate, in particular sub-investment-grade real estate, have generally seen the value of their properties plummet and in many instances the prospects for a robust and timely recovery in prices are not particularly compelling. Increasingly, owners wish to compare the risk/reward of continued ownership of classes and investment opportunities. Along these lines, a wide range of tools and techniques is available to empower real estate investors to tax-efficiently monetize their real estate investments to generate liquidity in order to diversify into other investment opportunities.

Selling outright

With property values generally down and the capital gains tax rate at an all-time low, some property owners might opt to simply sell their properties outright, and then turn to their financial advisor to deploy the after-tax proceeds in investments that are expected to outperform their real estate. However, depending on when the property was acquired and how much depreciation was taken for tax purposes, a good portion of the gain on the sale of the property could be ordinary income (recapture of depreciation) and subject to both federal and state tax.

Fortunately, several options, including the tax-free 1031 exchange, enable real estate investors to tax-efficiently monetize their real estate investments to generate liquidity in order to invest in other investment opportunities.

Related to each strategy, the mission is the same:

- Reduce the risk associated with having wealth concentrated in commercial real estate – Generate liquidity (cash) in order to diversify into other investment classes – Achieve optimal tax efficiency

A monetizing 1031 exchange is particularly useful in the current environment. The mechanics are straight-forward. The investor first sells his property and then reinvests the proceeds in another property of about the same value. In this case, the newly acquired property is an income-producing property that is leased (via a long-term, triple-net lease) to a large corporation that has an investment-grade credit rating. In doing this, the investor has essentially swapped his original real estate for a “bond-like” stream of income from the triple-net leased property that can be monetized for about 90% of the property’s value through a non-recourse loan against the property. Economically, it’s as if the investor acquired put protection with a strike price set at 90% of the value of the property and the put has been 100% monetized.

The results of a monetizing 1031 exchange are tantalizing for those investors who are seeking a tax-efficient exit from an appreciated property and who wish to deploy the bulk of the proceeds into other asset classes.

How it works in the real world

A few months ago, I was introduced to Fred, an 82-year-old man living in upstate New York, by Ken, his financial advisor. Fred owns a commercial property that was worth about $10 million back in 2007, but is currently valued at about $6 million. This property was at one time the main office and distribution facility of his family’s wholesaling business. The business was sold a number of years ago, but Fred retained this property and rented it out to a state agency until recently. It has been vacant ever since.

Despite Fred’s reluctance to sell for $4 million less than what the property was once worth, he is eager to diversify into other asset classes. As this property plummeted in value over the past few years, Fred watched his investment portfolio of liquid assets double from $500,000 to $1 million. Wishing that he had more cash for Ken to oversee, Fred considered selling his property outright.

However, the tax bite of a sale would hurt. Fred made substantial capital improvements to the property over the years that were fully depreciated for tax purposes and the tax basis of the property is therefore very low – almost zero. As a result, a significant portion of Fred’s nearly $6 million gain would be taxed as depreciation recapture at a 34% tax rate (25% federal plus 9% New York
State tax). Given Fred’s age and deteriorating health, triggering a significant tax did not seem prudent, given the fact that the stepped-up basis that would be achieved upon his death would completely eliminate the tax on the gain.

After analyzing various strategies with Fred and Ken, it was determined that a monetizing 1031 exchange made the most sense.

Here’s the plan: Fred will sell his property for $6 million and then reinvest the sales proceeds into another property valued at $6 million, which is triple-net leased to an investment grade corporation. Fred will then borrow against the property on a non-recourse
basis to generate liquidity.

The results are tantalizing:

- Fred can now borrow cash equal to about 90% of the value of the property (approximately %5.5 million) on a non-recourse basis – meaning that there is no personal liability, only the property is pledged as collateral for the loan.

- The loan is inexpensive because the income generated by the property offsets the cost of borrow.

- The margin rules of Reg T do not apply, so there are absolutely no limitations on the use of the proceeds. For instance, Ken can invest 100% of the loan proceeds in common stocks if that is the desired result.

- Fred retains 100% of the appreciation on the new property.

- Fred takes on a carry over basis – he has the same tax cost basis in the new property that he had in the old property -zero – and indefinitely defers the capital gains tax.

- Fred’s estate will receive a stepped-up basis in the property upon his death, thereby completely eliminating the tax on the gain, including both appreciation and depreciation recapture.

- Fred no longer has any management responsibilities with respect to the property – under a triple-net-lease maintenance of the property is the lessee’s responsibility.

This is a clearly a win-win solution for Fred and his financial advisor, Ken, because Fred can diversify into assets that he believes will grow more quickly than commercial real estate, and Ken can manage $5.5 million more for Fred.

Working together

The monetizing 1031 exchange is just one of several timely strategies advisors can introduce their clients to who are interested in diversifying out of commercial real estate into other asset classes.

Financial advisors normally oversee or manage only their clients’ liquid wealth and, as a result, clients who own commercial real estate, usually work in isolation with a local real estate broker, who in most instances has limited knowledge of the client’s overall financial objectives. This can and does often result in decisions and transactions that actually impede, rather than fulfill, the wealth planning goals of the client.

By bringing together an understanding of the client’s real estate holdings with other important financial and tax considerations, the financial advisor can help the client chart a more efficient path and make better decisions, while better
positioning himself to capture the proceeds of real estate liquidity events that increase assets under management.

Elizabeth Ostrander is director of business development at NAI Intelligent Edge, which helps financial advisors to counsel clients who own or desire to own commercial real estate. NAI Intelligent Edge is a joint venture between NAI Global, one of the largest real estate services providers worldwide, and Intelligent Edge Advisors, which focuses exclusively on the tax-efficient monetization of concentrated wealth.