Wednesday, July 29, 2009
Real Estate: What is it Good For?
Yes nothing. Actually, Zero. When was the last time an investment involving a “zero cash flow” sounded appealing? For most of us, that time would be never. However, there are times when “Zero Cash Flow” property can be of the most instrumental use. The benefits lay in the tax implications for those performing 1031 transactions, if used properly, they can allow someone to leverage a property with (if you can believe it) 90% debt. Of course that debt comes at a cost, namely all those rent checks that would normally be going to you, instead go to your lender (hence zero cash flow). However, after you are done paying off the debt, you would be left with a property completely paid off, most likely highly appreciated in value, and a deferment of the impending capital gains taxes.
Here’s how it works:
Say someone, Mr. Fornit for example, needs to sell a property worth $7 million, with only $1 million in equity and the rest in debt. The property was originally bought in 2000 for $2 million and if sold today, faces a $5 million capital gains tax liability. To avoid the impending capital gains tax, Mr. Fornit needs to enter into a 1031 but that means the new property must be of equal or more value. After satisfying the $6 million debt obligation, Fornit only has $1 million of cash to reinvest in a property that must be worth at least $7 million to comply with the 1031 rules. To buy a property you need to provide at least 30% of its price in equity. In this situation, Mr. Fornit’s equity would only equal 14% of the total cost.
By entering into a zero cash flow transaction, he can avoid these problems. A zero cash flow transaction is structured almost like a bond, so a bank will invest the $6 million needed into Mr. Fornit’s property and in return will receive the properties rent checks to pay off the debt. In this way the bank recoups its investment and Mr. Fornit ends up with a wholly owned property that satisfies his 1031 and defers his pesky IOU to Uncle Sam.
Note: This kind of transaction only works with investment grade properties to ensure payment stability.
So you may ask: what do zero cash flows from properties have in common with anti-hawkish music by Edwin Starr? One common theme: the best interests of the common man may not be directly aligned with the interests of Uncle Sam. So avoid your unnecessary taxes and stick it to the man!