The 1031 Roadmap

Advantages of a 1031 exchange include many things aside from the tax benefits. Investors can consolidate, diversify, move markets, or increase income potential on their current investment property. dst 2 black-01

Some people choose to do a 1031 exchange to acquire more income. For example, they can exchange vacant land for commercial or residential real estate. The investor is able to increase income potential by exchanging a property that is not generating any revenue, such as land, into real estate that has greater income potential like commercial and residential real estate.

Another advantage of doing a 1031 exchange is consolidation. Depending on the investor’s situation, they may not want to manage multiple properties. They can exchange their properties into one larger investment property that is easier to manage. Others are tired of managing properties and of being a landlord altogether. These investors can exchange from a residential or commercial property into a more manageable and less time consuming piece of land.

Some investors are looking to diversify. With a 1031 exchange they can exchange one property for multiple property types. For example, an investor can exchange their residential investment property into a commercial, residential, and vacant piece of land. This is one of the most attractive of the advantages of a 1031 exchange!

A 1031 exchange is great for investors who have multiple properties in other states or for investors who are moving markets. Instead of traveling from state to state to manage multiple properties, investors can exchange the out of state real estate into property that’s in one state. If the investor is moving markets, for example from one state to another, they can exchange their investment property in the current states for an investment property in another state.

Every situation is unique when considering the advantages of a 1031 exchange, and it is always advised that the taxpayer consult with his or her tax advisors before making any decisions!

For more information, visit www.DST.investments.

Winter Solstice

They say its always darkest before the dawn, which seems appropriate as we meet the Winter Solstice today, at the lows of 2018.

There is a lot of commentary out there right now about hos investors are ‘worried’ about certain things like Brexit, slowing economies in China and Europe and if that slowing will seep into the U.S.  All these areas of concern have been with us for most of the year.  I have pointed out the Chinese credit impulse (slowing) more than a few times.  Housing and auto sales have been slowing for months.  The only difference is now there is a market decline and all these issues are being discussed.   If the market had not been declining these issues would still be with us, only accompanied by the tag line: “Investors shrug at concerns in Europe”.

In past posts I have described the coming year over year comparisons, 2018 v 2019, regarding earnings and GDP growth.  Every time I have mentioned that 2019 will look much worse than the stellar numbers put up in 2018, thanks largely in part to the one time cut in taxes.   That gave markets a boost and it was hoped that business investment, and wages would go up as a result.  Well it’s the end of 2018 and were still waiting.

The Federal Reserve gave a modest tip of the hat towards global economic concerns by reducing its estimate of rate increases in 2019 from 3 to 2.   There were even rumors that the Fed would skip raising its rate on December 19th and guide to 0 rate increases in 2019.   The Fed NEVER overtly bows to market or political pressures outside of an official recession or panic.   The Fed is in the process (as usual) of raising rates into the beginning of a recession.   Besides the yield curve, there are several other indicators that make recession in 2019 likely.  These indicators have been leaning this way for several months, and finally have tipped far enough that the markets are now concerned and discounting this likelihood.

As this is likely the beginning of a bear market (average -33% post WW2 era), we should expect large rapid moves, both down AND up in the markets.  During the bull market, a 2-4% pullback was common and quickly bought.  Today we see 2-4% intraday moves that continue to fall to hold support.  I expect several more percentage points south before a significant rally in stocks in the first few months of the year.   This will be an opportune time to reassess one’s risk tolerance and goals over the next 1-3 years, as well as make sure that one’s portfolio is properly diversified across asset classes. When stocks go down there are often other asset classes that are performing better, the core idea behind diversification.

Keeping Pace with Inflation

Inflation has been called the silent killer of wealth. It’s rarely discussed and many dollar picretirement income strategies ignore it completely. But over time, the steady increase in the cost of living can have a profound negative effect on your standard of living in retirement.

How inflation destroys wealth

As this chart shows, even at a modest rate of inflation, your spending power could decline by nearly 40% over the next 20 years.inflationNo one knows what the future may hold for inflation, but we do know that the Federal Reserve aims to keep the rate between 1% and 3% per year, and it has reached double digits in the 1950s, 1970s and 1980s.

Happy Thanksgiving !

Please note our office will be closed on Thursday, November 22 and Friday, November 23, 2018 in observance of the Thanksgiving holiday.  Normal operating hours will resume on Monday, November 26, 2018.

Feel free to contact me should you have any questions or if you have specific needs that require special attention.  You can reach me at 239-287-3789 or via email at pmcintyre@namcoa.com.

Have a safe and happy holiday!

 

Due Diligence for Commercial Real Estate Transactions

Due diligence usually refers to the time after signing a contract that the buyer has to inspect the property and make a decision whether they want to buy the property or lease the property or otherwise go forward with the transaction.

It’s important during due diligence period that you gather all of your information. You have to get your inspections done, you have to get your environmental inspections done, you have to gather all the documents that relate to the property, you have to do your zoning checks and you generally have to be one hundred percent certain that you are going to go forward with this deal.

If you don’t gather all that information, when due diligence expires, your deposit money may become non-refundable. Before due diligence expires, you can still walk away. It’s what’s also called a Free Look Period. It’s important to have a good broker and a good team of professionals around you to conduct all of these inspections, gather all of the documents, tell you what everything means and advise you whether you should go forward or not. A good broker will quarterback all of these players and make sure that everything is done timely and keep you on track.

The scope, intensity and focus of any due diligence investigation of commercial real estate depends upon the objectives of the party for whom the investigation is conducted.

A  “Due Diligence Review” will address issues important to the Seller, Developer and Lender including:  

  • WHAT IS CONSIDERED TO BE “THE PROPERTY”Bank Property
  • PURCHASE PRICE & OTHER CONSIDERATION
  • TITLE
  • SURVEY
  • BUILDING INSPECTION
  • THIRD PARTY SERVICE AGREEMENTS
  • ZONING
  • EXISTING LEASES
  • PURCHASER FINANCING
  • ENVIRONMENTAL ISSUES

IRS Provides Guide for New Tax Law

Last week the Internal Revenue Service (IRS) issued a new publication to help taxpayers learn about the recent tax reform law and how it affects their taxes.  The IRS estimates they will need to create or revise more than 400 taxpayer forms, instructions and publications for the filing season starting in 2019 — more than double the number of forms it would create or revise in a typical year.

While the 2018 Tax Cuts and Jobs Act includes tax changes for both individuals and businesses, this publication  —  Tax Reform Basics for Individuals and Families— is specifically geared to individual taxpayers. According to the IRS, the publication breaks down the law in easy-to-understand language and highlights the changes that taxpayers will see on their 2018 federal tax returns they file in 2019.

Specifically, the new guide provides important information about:

  • Increasing the standard deduction
  • Suspending personal exemptions
  • Increasing the child tax credit
  • Adding a new credit for other dependents
  • Limiting or discontinuing certain deductions

IRS Tips to Prepare for 2018 Federal Tax Filing

Federal Income Withholding

What You Need to Know

  • Due to tax changes in the Tax Cuts and Jobs Act, many taxpayers’ withholding went down in early 2018, giving them more money in their paychecks in 2018.
  • You may receive a smaller refund – or even owe an unexpected tax bill – when you file your 2018 tax return next year, especially if you did not adjust your withholding after the withholding tables changed.Other changes that affect you and your family include increasing the standard deduction, suspending personal exemptions, increasing the child tax credit, adding a new credit for other dependents and limiting or discontinuing certain deductions.

What You Need to Do

  • Use the IRS Withholding Calculator to perform a paycheck checkup to help you decide if you need to adjust your withholding or make estimated or additional tax payments now.
  • Use your results from this calculator to submit a new Form W-4, Employee’s Withholding Allowance Certificate, to your employer.
  • Make estimated or additional tax payments if the withholding from your salary, pension or other income doesn’t cover the 2018 income tax that you’ll owe for the year. Form 1040-ES, Estimated Tax for Individuals also has a worksheet to help you figure your estimated payments.

To download IRS Publication 5307, Tax Reform Basics for Individuals and Families, Click here.

Trends of the Wealthy

Let’s talk about some trends that are changing how private investors and especially the ultra-wealthy families worth $100 Million plus are allocating their capital.

While the mass affluent and billionaires are studied and talked about relentlessly in the media and by the general public, there are very few resources or facts available on those who are worth $100 million up to $2 billion.

These individuals are sometimes called Centimillionaires, a term rarely used.  This was similar to the use of the term “family office” used prior to 2000, and I think in the future the mass media, wealth managers, and dozens of other types such as industry service providers are going to sit up straight and realize that while there are only around 3,000 billionaires depending on what sources you trust, there are between 40,000 and 60,000 centimillionaires.

The families in the $100 million to $2 billion range need a lot of help, do not have as many gatekeepers as other 2 plus billionaires, and are less “famous” so they aren’t being pinged hundreds of times an hour with offers, pitches, requests and other inquiries.

Below are two trends we are seeing among Centimillionaires:

Transferring of Values (Not Capital): While the general public talks about baby boomers and the transfer of that wealth being central to their aging, Centimillionaire families seem to worry more about transferring values, responsibilities, family stories, and know-how being passed on to the next few generations.  Transferring of wealth in a tax efficient matter is important, but not much of that matters if the family tears themselves apart, wastes the money, embarrasses the family name, and squanders what past generations worked so hard to build as a family culture and legacy.  Many families are afraid that their family stories, governance structures, experience, etc. in creating the wealth is going to get lost between generations, and the true loss is either the family staying connected and/or the principles that lead to the wealth being created in the first place.  The wealth is truly transferred within the family values – not just a “warm fuzzy family emotions are more important than money” approach, but truly the only preservation and growth of the capital long-term is via the values/mission of the family.

Outsourcing: Most family offices are realizing that the only thing they should be doing in-house is what they did to create their wealth in the first place, the space where they believe there is great cross-over in a rising tide opportunity, using their experience and skills where they actively want to be 100% focused.  Trying to “recreate the wheel” just does not make sense.

Many single family offices, whether they hire a private bank or multi-family office or not, are leaning towards full outsourcing of their managers/stock/bonds/market exposure, a full in-house deployment of their investment back into the niches where they are playing offense, and then an in-between strategy of going through independent sponsors and some direct investments when it comes to real estate allocations.

This outsourcing trend with varying levels of accountability, control and transparency is likely to continue increasing with those with over $100 million in assets.

At NAMCOA we focus on adding real value, resources and peer connections to centimillionaires is one of those areas where those positioning now, building relationships now, and adding value now will do well long-term just as they will in the growing family office space.

 

Summertime Wanes while Bull Market Waxes

Trade tensions, moderating global growth, political drama, rising interest rates that boost borrowing costs, and a gripe with Turkey and others – all be damned! While these matters may pose risks, they haven’t collectively prevented key stock market indices from claiming new highs.

Last week the Russell 2000 (small cap) index closed at new highs as did the S&P Mid Cap Index as well as the large and mega-cap index, the S&P 500. It took the S&P nearly 7 months to take out its previous high from late January. The S&P closed at 2,898 on Tuesday (August 28th), and appears that it’s only a matter of time before we pierce 3,000. Amazingly, 50 years ago (June, 4, 1968) the S&P first broke through 100!

Asset Class Returns since March 2009 - July 2018
Asset Class Returns since March 2009 – July 2018

Since March 2009 through late August 2018, the S&P 500 is up nearly 325%. While short-term risks have rocked the boat, U.S. stocks have outpaced other global markets – over that time, and particularly this year – on strong corporate earnings growth and more favorable economic fundamentals.

While this year’s rally had been largely driven by a few large tech names, as summer rolls along it’s become more broad-based than tied to a handful of stocks which is healthier for investors.

Let’s quickly look back as to what’s driven the market rally for the past 9 ½ years. Mainly it’s been fundamentals – record corporate profits; an expanding economy; an accommodating Federal Reserve that gave us quantitative easing (QE) and zero interest rate policy (ZIRP) to get the economy back on track (and today, rates are still low and rate hikes are gradual, encouraging investors to look to riskier assets); low inflation that supports higher valuations; record stock buybacks; and economic confidence that supports higher valuations.

What’s held investors back from truly embracing the rally? The Wall of Worry!

This bull market run has been questioned frequently as there have been lots of concerns to sidetrack one from sticking to their long-term investment aims and financial goals – European Union economic turmoil; U.S. federal debt downgrade; QE’s end; China worries; extended valuations; collapse in oil prices; Brexit; political turmoil at home; Fed rate hikes; trade tensions; and the occasional currency crisis (to name a handful).

Like a car, you drive by looking ahead not in your rearview mirror, so let’s look ahead. Barring an unforeseen shock, bear markets coincide with recessions. While we’re late in the cycle, leading indicators suggest odds of a near-term recession are low. Last week the Atlanta Fed raised their estimates for 3rd quarter GDP to +4.6%, marking an economy that’s getting stronger.

GDP Growth - Economic Growth on Pace for Best Year since 2005
GDP Growth – Economic Growth on Pace for Best Year since 2005

Stock fundamentals, while stretched, remain favorable. Today’s forward price-to-earnings (P/E) ratio for the S&P 500 is 16.6, according to FactSet. While it’s above the 5-year average of 16.2 and the 10-year average of 14.4, it’s high but not unreasonable. Low inflation and low interest rates support higher valuations.

Corporate Earnings Growth - Actual and Expected
Corporate Earnings Growth – Actual and Expected – By Quarter – as of August 2018

There is a lot of speculation about when the bull market will end. While I continually look for signs or the symptoms of an impending recession, I don’t see them now. Some are worried about the yield curve inverting (that is the term premium going away – or the extra yield that investors require to commit to holding longer-dated bonds than shorter-term bonds).  We still have further to go before the 10-year Treasury minus the 3-month Treasury spread inverts (2.87%-2.11%=+0.76%, as of August 28, 2018). The Fed could raise rates by another 1.0% over the next 9 months, so it’s important to monitor easy financial conditions as they gradually start to tighten. I’ll be paying attention as rising interest rates and wage inflation begin to weigh on peak corporate profit levels. Perhaps this is as good as it gets?! (reminds me of a Jack Nicholson movie 20 years ago).

Record Profit Margins of 9.73%, Net Income Relative to Sales for S&P500 through 2q2018 Earnings Season
Record Profit Margins of 9.73%, (net income relative to sales for the S&P 500 though 2q2018 earnings season) Source: Nuveen, LLC

If you’re an investor that has maintained a diversified, disciplined approach to investing over the duration of the bull market, you have benefited and should be applauded for sticking to your plan. One thing is certain, markets move in cycles and giant beanstalks don’t grow into the clouds. As such, the key is to make sure that your financial plan has the right asset allocation to help you keep moving toward your long-term goals as the market keeps moving too. Let me know (or one of my fellow advisors) if you have questions, happy to help.

Enjoy the vestiges of summer and your Labor Day weekend; I hope it’s relaxing and fun. And if you have kids/grand-kids, I wish them a good school year ahead. For me, it’s kick-off to football season and I’m ready to cheer on my favorite teams. In San Francisco autumn means warmer, sunnier days ahead than the persistent fog bank that’s called summertime.

Eric Linser, CFA

Benefits of the Tenant-In-Common Vs. Delaware Statutory Trust

Real Estate Tenant-In-Common or TIC Offerings 

Technically there are two types of Proportional Ownership products referred to as Tenant In Common  (TICs), which are structured as a securitized TIC or a Real Estate TIC.

Since the favorable ruling by the IRS in 2004 allowing a Delaware Statutory Trust, under specific restrictions, to be eligible for a 1031 exchange the use of securitized TICs has diminished.  Some security professionals have abandoned the TIC structure for the more lucrative business model that the DST format offers. For the sake of this comparison we will focus on the Real Estate TIC and how it compares to a DST.

A tenancy in common investment (better known as a real estate TIC) is an investment in real estate which is co-owned with other investors. Since the taxpayer holds a deed to real estate as a tenant in common, the investment qualifies under the like-kind rules of IRS Section 1031.

This type of an investment can appeal to taxpayers who are tired of managing real estate. TICs can provide a secure investment with a predictable rate of return. Real Estate TICs are often developed by commercial real estate professionals with an emphasis and expertise on the underlying real estate asset. They are marketed by real estate professionals and not security brokers.

A small number of TIC sponsors take the steps necessary to structure their TIC so that the investment is a real estate investment not subject to state security laws. Usually this means that the TIC sponsor will not be responsible for management of the investment and independent management will be employed by the owners.

Real Estate TICs have significant limitations when it comes to leveraging the properties with debt or investing in large complex commercial real estate that require ongoing management where the quality of the return is reliant on a third party. These limitations force Real Estate TIC sponsors to invest in debt-free high-quality Triple Net Leased properties. These limitations tend to produce a simple structure with a high level of safety and security.

The largest draw back to a Real Estate TIC is that each owner must take an active roll in decision making. This can be cumbersome with even a modest number of owners. The need for decisions can be mitigated up front by not taking out debt against the property and engaging in long term Triple Net Leases with investment grade tenants. This structure effectively eliminates the need for decisions in the near and intermediate term.  The tenant in common agreement for each property sets forth the structure whereby these decisions are to be made. Some can be structured with drag rights or other provisions to facilitate decision making.  Investors should closely review the tenant In common agreement.

Delaware Statutory Trust or DST Investment Offerings

In an effort to create an instrument that would increase the profitability for securitized TIC Sponsors as well as facilitate the placement of debt on properties the securities industry joined with commercial lenders and invested significant resources in developing a complex alternative fractional ownership structure that would overcome what they saw as the weaknesses and limitations of the traditional Real Estate TIC Investment Property offerings.  The result was the fractional ownership structure known as the Delaware Statutory Trust or DST.

The Internal Revenue Service issued Revenue Ruling 2004-86 on August 16, 2004. This ruling offered seven significant management limitations that if followed, permitted the use of the fractional ownership structure of the Delaware Statutory Trust or DST to qualify as replacement properties as part of an investor’s 1031 Exchange transaction.

Each co-investor owns an individual beneficial interest in the Delaware Statutory Trust. The DST itself shields the investor from liability with respect to the underlying investment property owned and held inside the DST.  These instruments are created and sponsored by securities professionals with expertise and an emphasis on creating a quality security instrument. They are sold by securities brokers with no required training, experience or education in real estate and are governed by the SEC.

As discussed above individual investors in a Real Estate TIC structure must vote on all major property decisions. Without a majority owner and appropriate structure, it can be somewhat dysfunctional to get the individual TIC Investment Property co-investors to agree on major decisions. To address this issue, the individual investors or beneficiaries in a Delaware Statutory Trust are not permitted to vote. In the DST structure partners relinquish the agency and authority to make all decisions regarding the management and wellbeing of the property and investment and vest it in a single trustee – the sponsor. However, for the DST to be 1031 qualified the Trustee must relinquish the right/ability to make major property decisions. This can create an even more difficult situation than the TIC structure.

Financial institutions can loan to a DST entity. Because the loan is made to the Trust there is no need for a lender to separately underwrite each co-investor for purposes of loan qualification since the DST is the borrower and not each individual investor. This structure allows DSTs to hold multiple properties with multiple and varied debt structures. This can provide a false sense of security to investors. Although individual investors are not underwritten by the lender or personally sign on a loan, their investment is used as collateral and is 100% at risk in the event market conditions, fraud or other issues create a default. The debt structure of any DST should be thoroughly evaluated and understood by each individual investor.

The Seven Deadly Sins of a DST

Internal Revenue Ruling 2004-86, which forms the income tax authority for considering a Trust as Real Estate for use with a 1031 Exchange has extensive prohibitions over the powers of the Trustee of the DST. In a 1031 qualified DST structure, the trustee is restricted from many actions that would otherwise be normal in typical ownership structures such as an LLC. The trustee may not renegotiate leases, make capital calls, or even re-finance the property. These IRS imposed restrictions are sometimes referred to as the “seven deadly sins,” and include the following:

  1. Once the offering is closed, there can be no future equity contribution to the Delaware Statutory Trust or DST by either current or new co-investors or beneficiaries.
  2. The Trustee of the Delaware Statutory Trust or DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.
  3. The Trustee cannot reinvest the proceeds from the sale of its investment real estate.
  4. The Trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
  5. Any liquid cash held in the Delaware Statutory Trust or DST between distribution dates can only be invested in short-term debt obligations.
  6. All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis, and
  7. The Trustee cannot enter into new leases or renegotiate the current leases.

The Springing LLC aka The Nuclear Option

These restrictions are significant. They are put in place to enable favorable consideration by the IRS and may even seem to provide protection for individual investors. However, they place significant limitations on the trustee in the event tenants default or market conditions require deviation from the management plan. In the event any of the above seven restrictions need to be violated, there is a way out. Delaware law permits conversion of the trust to an LLC. This is referred to as a “springing LLC”. This will allow for any or all the prohibited actions to be performed by the trustee without the consent of the members. This is the ultimate safeguard, but it comes with a massive price. This action will disqualify any of the tax-deferral benefits afforded by Section 1031 to the initial investors. The springing LLC clause is required in most DSTs because it gives the lender additional comfort that the trustee can perform necessary actions in the best interest of the bank even though activating this clause will have detrimental tax consequences to all 1031 investors in the fund. The alternative to having a Springing LLC clause is not pretty and typically does not provide the Trustee the tools necessary to react to even slight deviations in the anticipated investment course. This could result in a catastrophic failure of the Trust during a market correction.

For more information on 1031 strategies, please contact us.