CHOOSING AN EXIT STRATEGY FOR BETTER RETURNS
The Finish Line Is Not The End Of The Race
Many private syndications buy commercial properties to hold for a significant period of time. Maybe five to seven years. Then the property is sold and you get a windfall. You expect to receive back your initial investment along with a significant profit. Your investment did well. It was a winner.
And then, at the end of the year, the tax man reaches in for a large fistfull of dollars. Like stacks of Benjamins. Gone.
But it doesn’t have to be this way.
So let’s look at some options.
WHAT WAS THE ORIGINAL PLAN?
The original plan was likely conceived with consideration given to the available financing. Many commercial loans have a 7-year term or balloon. Lenders do not want to be locked in for longer periods of time with large amounts of cash. If interest rates go up a few years from now they want to take advantage of the higher rates.
Many people who choose to invest in commercial properties and syndications seek to maintain a higher internal rate of return. This may be optimized by forcing appreciation and creating higher cash flow in the early years of owning a property. You can read more about forcing appreciation here. Cash flow may not increase as much in later years, so investors may seek to switch and own a different property with higher potential.
The most common strategy is to sell and take the profits. Then take some or all of the cash and invest in another syndication. But, similar to single-family real estate, there are other options.
We like to anticipate having a “capital event” to return initial investment and profits to our investors.
How is that accomplished and what would a “capital event” look like?
Sell and take profits.
This may be the easiest and most straight-forward. Investors take their cash and pay capital gains tax on the profits. Depreciation allowance is recaptured and taxes are also paid on it. Also note that the long term capital gains tax rate is generally lower than an ordinary income tax rate.
It is not uncommon for at least half of the profit to be in the form of capital gains. This is especially true when the value has increased due to forced or market appreciation.
Like with a sale, some or all of the initial investment is returned to investors. However, accumulated equity remains invested. The resulting cash flow may be lower but investors are free to re-invest their cash in another opportunity.
No taxes are due since this is not a sale.
This works like playing Monopoly and trading in houses for a hotel. You can upgrade to a larger property without having to pay taxes yet on the gains from the sale. Tax liability on the gains is transferred to the new property. Timing can get tricky as timelines must be strictly adhered to and proceeds must be reinvested within 180 days.
A buyer may be willing to pay more with some seller financing. The syndication gets to enjoy a monthly payment with interest. Usually there is a balloon at the end.
This allows the property to be transferred to a new owner without having to pay all of the taxes at the time of sale. Rather, they are determined based on an installment sale.
Seller financing may be used to carry back a second mortgage, making it easier for a buyer to purchase with a smaller down payment or assume an existing mortgage.
Of course, one must also consider any mortgages on the property and whether or not they can be assumed by the new buyer.
Sell your share
It may be possible to sell your ownership interest in a syndication, independent of a “capital event.” It could be sold to another current investor. It is likely that any sale needs to be approved by the syndicator.
A syndicator may have “first right of refusal”, or the right to buy your units at the price that you agree to sell them to someone else.
Syndicator may have the right to buy out other investors at a prior disclosed price or maximum rate of return. This is typically in the event that the property has performed extremely well.
Pass on to heirs.
Most people don’t go into a syndication planning to pass the particular investment on to their heirs. But it is a very effective way to save on taxes. When you leave this world, the property gets a step up in basis, so no taxes will be due on the capital gains.
Another benefit to passing ownership in a syndication to heirs is that it is a passive investment. A portfolio of houses may have considerable wealth but lots of complications with property maintenance and management. Your heirs will need to have at least a basic understanding of how to maintain the investment.
WHAT STRATEGY IS BEST?
When it comes to choosing your exit strategy there is no clear-cut solution that works every time. While the typical sale can be the cleanest way to take and distribute profits, the 1031 exchange allows taxes to be deferred. This can get complicated with more investors in the syndication but yield significant benefits. One also needs to consider tax brackets and other investment opportunities to keep the capital working for you.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.