Your clients don't need a wizard to know when to do 1031 exchanges

Robert Bruyneel, branch manager, AmericaOne Finance Inc.

As published in Scotsman Guide's Residential Edition, April 2006.

Imagine a group of investors standing in front of the Wizard of Oz. They made it to Emerald City with a powerful return on their investments and are now asking the wizard what they should do next.

They ask for advice as to when they should take the 1031 tax-deferred exchange versus when they should take the hit of the capital-gains tax. This question is an important one in this time of rapid growth. When selling a home, the capital-gains tax is always an issue for investors in determining their next investment strategy.

Homeowners who have occupied their property for two of the past five years will be glad to know the good witch has blessed them with a capital-gains-tax exemption.

For those investors who have speculated and earned a nice wealth accumulation in a non-owner-occupied investment home, on the other hand, there are two choices: 1. Follow the yellow-brick road and the promise of a 1031 exchange; or 2. Take another path to the capital-gains tax.

When turning exchanges on single-family dwellings, we typically see investors who may have bought their first property for, let's say, $90,000 to $150,000. The current property value nets them $50,000 to $100,000. In a 1031 tax-deferred exchange, they must exchange it for a like or similar property.

Here's the problem: Try finding a like property for the now-elevated price and finding a renter who can afford the mortgage payments that come with it. When you factor in the cost of maintenance, loss on the monthly mortgage payment because of vacancies, rents that can't cover the mortgage, and taxes and insurance, it may be a better option for investors to pay the capital-gains tax. They can then start over using the original formula of finding a fixer-upper with a low mortgage payment and putting in some sweat equity to invest their money.

The best option is to look for a multifamily investment like a duplex or quad that can cover the payments. Barring this, a flex-option loan can allow your clients to flex their payments down to the mid-1-percent payment bracket to create a positive cash flow or at least lower their payments in a vacancy scenario. As long as the market is outpacing the negative amortization, this should be a viable option.

If your clients are lucky enough to have a multifamily dwelling, they can use the equity gain and 1031 exchange to buy a more profitable investment. Perhaps they can find an exchange with lower maintenance costs and a higher rental history. Engage them in a short-term loan, such as a hybrid ARM or straight three- to five-year term, or, if the index is right, an ARM that is amortized over 30 years to create an income stream.

Whatever their choice, investors should always have a solid start and exit point for their investments, which they can ensure by having a clear business plan.

In real estate, the business-plan requirement is self-imposed and usually followed only generally. But one of the biggest mistakes real estate investors make is not having a plan for their investments.

If your clients were in any other business, they would have at least a five-year plan for that business. Not only is it a smart thing to do, but it's also likely that such a plan was required by the lender that financed their dream. The financing usually has a condition that someone in the organization be experienced in managing the business plan set forth in the acquisition phase.

All transactions are different, and each has its own matrix of conditions. In helping your clients develop their plan, find out if they are collectors or investors. If they are collectors, they gather properties to sell and usually engage a 15- or 30-year fixed loan. If they are investors, they typically look at short-range scenarios -- about one to three years. Do your research on the market, and engage the right loan for your clients' transactions.

Remember, buying single-family residences and turning them over in 1031 exchanges will soon put your clients' mortgage payments higher than rents will afford. Help them avoid this by looking at an exit strategy that involves multifamily units or apartments. With this strategy, your clients can continue the growth of their investments for retirement.

Robert Bruyneel is branch manager for AmericaOne Finance Inc. in Visalia, Calif. He also is operations director for C & B Development Inc., which provides financing, consultation and development for commercial, residential and unique properties. He conducts investment "how to" seminars and has been published more than 30 times in the financial field. For seminars, training and loans, contact him at (559) 636-3601 or loansforyou2005@yahoo.com, or visit his Web site at www.candbdevelopment.com.