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Tax Deferred Exchange Alternative Strategies Analysis


Alternative strategies examined in an Exchange Feasibility Review will vary with the motivation of the investor. In a situation where an investors primary goal is to dispose of a particular property, a review might include the analysis of several alternative Replacement Properties as well as variable financial structuring approaches. This Exchange Feasibility Review is based on the motivation of this particular investors goal of harvesting enough cash to acquire a particular office building.

John, our investor, is interested in acquiring an office building that he can purchase for $750,000. Five years ago, together with his CCIM, John structured the acquisition of an apartment building for $500,000 that continues to be an excellent investment for him today. Since he has a buyer that is willing to pay $650,000 for the apartment building, John feels that a tax-defered exchange out of the apartment building would be an ideal strategy for acquiring the office building.

In light of the current favorable climate for tax deferred exchanges, John meets with his CCIM to discuss the structuring of his exchange (apartment building for the office building). John's CCIM recommends reviewing alternative strategies for maximizing after tax return and potential for wealth accumulation over a 5 year holding period.

Note: Based on the review of alternative strategies summary outlined below, John opted to refinance his apartment property and acquire the office building with the refinance proceeds. Holding both properties over a 5 year period far out performed an exchange in both "Internal Rate of Return" and "Wealth Accumulation". It should be noted that a reason for the poor performance in Analysis "E" Exchange is that the "Replacement" property was fairly close in the value to the "Relinquished" property. Had the exchange been structured leveraging in to a higher value in "Replacement property, the exchange transaction would have performed more favorably.

Prior to embarking on a study of alternative strategies, John's investment base in his apartment building must be established (net proceeds of sale after mortgage payoff, cost of sale, and capital gain tax).The purpose in establishing the investment base in an investment property is to determine how much you are (in theory) re-investing in that property should you decide to hold the property "as is". . . what your after tax returns and wealth accumulation would be over a given holding period, and how they would compare with alternative strategies.

They examine the following alternative strategies.
"A" Investment base analysis
"B" Hold apartments as is
"C" Refinance apartments
"D"Buy office building with proceeds of refinance
"E" Exchange apartments for office building
The assumptions calculated In each of the above alternative strategies are ; 28% tax bracket, 20% capital gain rate, 6% cost of sale, 25,000 annual passive loss allowance.
Let's start with a summary of the detailed analysis contained in this report, then proceed to the in-depth analysis in "A","B", "C","D", & "E".

Alternative Strategy Summary of annual after tax cash flows over a 5 year holding period.

YEAR "B" Hold as is "C" Refi-Apartments "D" Buy office bldg Combined "E" Exchange
0 (236,469) (85,164) (150,000) (235,164) (272,305)
1 15,519 9,958 2,700 12,658 11,906
2 17,087 11,589 4,517 16,106 13,744
3 18,698 13,272 6,216 19,488 15,508
4 20,349 15,009 7,966 22,975 17,330
5 22,039 16,799 9,766 26,565 19,209
Sale Proceeds EOY 5 336,067 178,864 242,591 421,455 318,729
After Tax IRR 14.10% 27.47% 13.33% 18.73% 8.48%
Wealth Accumulation EOY 5 440,628 252,860 276,574 529,434 405,133
(Wealth accumulation factors used; safe rate 4%, reinvestment rate 6%)

"A" INVESTMENT BASE ANALYSIS(apartment building)

CAPITAL GAIN

Sale Price 650,000
Less Cost of Sale 39,000
Less Adjusted Basis 431,818
Capital Gain 179,182

PROCEEDS OF SALE
Sale Price 650,000
Less Cost of Sale 39,000
Less Mortgage Balance 338,695
Proceeds Before Tax 272,305
Capital Gain Tax @ 20% 35,836
Proceeds After Tax 236,469 (INVESTMENT BASE)
* * *End of Analysis "A"; Investment Base* * *
ANALYSIS "B" HOLD APARTMENTS "AS IS" 5 YEARS

ASSUMPTIONS:
Mortgage Balance 338,695 Monthly 3,743.93 (10.5%)
Investment 236,469 (Investment base in apartments)
Depreciation/Improvements 375,000 27.5 Yrs, S/L, 22.5 Yrs remaining
Net Operating Income (NOI) 65,000 4% annual growth
Tax Bracket 28%
Capital Gains Rate 20%
Passive Loss Allowance 25,000
Original Basis 500,000
Sale Price end of yr 5 719,000
Cost of Sale 6%
Hold Apartments as is 5 yrs; summary of annual after tax cash flows, detailed cash flow analysis in the sections that follow.
YEAR CASH FLOW
Initial Investment (236,469)
1998 15,519
1999 17,087
2000 18,698
2001 20,349
2002 22,039
2002 336,067 Net Proceeds of Sale
Internal Rate of Return 14.10%
Accumulation of Wealth 440,628
Hold Apartments as is 5 yrs; CASH FLOW ANALYSIS
YEAR 1998 1999 2000 2001 2002
Initial Investment 236,469
Mortgage Balance EOY 328,867 317,955 305,842 292,393 277,462
YEAR 1998 1999 2000 2001 2002
Net Operating Income 65,000 67,600 70,304 73,116 76,041
Interest Deduction 35,099 34,016 32,813 31,478 29,996
Depreciation 13,636 13,636 13,636 13,636 13,636
Taxable Income 16,265 19,948 23,854 28,001 32,408
YEAR 1998 1999 2000 2001 2002
Net Operating Income 65,000 67,600 70304 73,116 76,041
Less Debt Service 44,927 44,927 44,927 44,927 44,927
Cash Flow Before Taxes 20,073 22,673 25,377 28,189 31,114
Income Tax 4,554 5,585 6,679 7,840 9.074
Cash Flow After Taxes 15,519 17,087 18,698 20,349 22,039
Analysis of Sale Proceeds EOY year 5
Original Basis 500,000
LessTotal Depreciation 135,795
Adjusted Basis 364,205
Sale Price 719,000
Less Cost of Sale 43,140
Less Adjusted Basis 364,205
Capital Gain 311,655
Capital Gains Tax @ 20% 62,331
Sale Proceeds:
Sale Price 719,000
Cost of Sale 43,140
Less Total Encumbrances 277,462
Proceeds Before Taxes 398,398
Total Tax Liability 62,331
Proceeds After Taxes 336,067
* * *End of Analysis "B" Hold Apartments "as is"* * *
ANALYSIS "C" REFINANCE APARTMENTS HOLD 5 YEARS

ASSUMPTIONS:
New Mortgage 490,000 Monthly 4,408.66 (9%)
Investment 85,164 (Investment base in apartments after taking out 151,305 refinance proceeds)
Depreciation/Improvements 375,000 27.5 Yrs, S/L, 22.5 Yrs remaining
Net Operating Income (NOI) 65,000 4% annual growth
Tax Bracket 28%
Capital Gains Rate 20%
Passive Loss Allowance 25,000
Original Basis 500,000
Sale Price end of yr 5 719,000
Cost of Sale 6%

Refinance Hold Apartments 5 yrs; summary of annual after tax cash flows, detailed cash flow analysis in the sections that follow.
YEAR CASH FLOW
Initial Investment (85,164)
1998 9,958
1999 11,589
2000 13,272
2001 15,009
2002 16,799
2002 178,864 Net Proceeds of Sale
Internal Rate of Return 27.47%
Accumulation of Wealth 252,860
Refinance apartments hold 5 yrs; CASH FLOW ANALYSIS
YEAR 1998 1999 2000 2001 2002
Initial Investment 85,164
Mortgage Balance EOY 480,824 470,787 459,808 447,800 434,665
YEAR 1998 1999 2000 2001 2002
Net Operating Income 65,000 67,600 70,304 73,116 76,041
Interest Deduction 43,728 42,867 41,925 40,895 39,769
Depreciation 13,636 13,636 13,636 13,636 13,636
Taxable Income 7,636 11,097 14,742 18,584 22,636
YEAR 1998 1999 2000 2001 2002
Net Operating Income 65,000 67,600 70304 73,116 76,041
Less Debt Service 52,904 52,904 52,904 52,904 52,904
Cash Flow Before Taxes 12,096 14,696 17,400 20,212 23,137
Income Tax 2,138 3,107 4,128 5,204 6338
Cash Flow After Taxes 9,958 11,589 13,272 15,009 16,799
Analysis of Sale Proceeds EOY year 5
Original Basis 500,000
LessTotal Depreciation 135,795
Adjusted Basis 364,205
Sale Price 719,000
Less Cost of Sale 43,140
Less Adjusted Basis 364,205
Capital Gain 311,655
Capital Gains Tax @ 20% 62,331
Sale Proceeds:
Sale Price 719,000
Cost of Sale 43,140
Less Total Encumbrances 434,665
Proceeds Before Taxes 241,195
Total Tax Liability 62,331
Proceeds After Taxes 178,864
* * *End of Analysis "C" Refinance apartments hold 5 yrs* * *
ANALYSIS "D" BUY OFFICE BUILDING with proceeds of apartment refinance
ASSUMPTIONS:
Purchase Price 750,000
Mortgage 600,000 Monthly 5,398.36 (9%)
Investment 150,000 (Refinance proceeds)
Depreciation/Improvements 565,000 39 Yrs, S/L,
Net Operating Income (NOI) 67,500 4% annual growth
Tax Bracket 28%
Capital Gains Rate 20%
Passive Loss Allowance 25,000
Original Basis 750,000
Sale Price end of yr 5 850,000
Cost of Sale 6%

BUY OFFICE BUILDING with refinance proceeds, hold 5 yrs; summary of annual after tax cash flows, detailed cash flow analysis in the sections that follow.
YEAR CASH FLOW
Initial Investment (150,000)
1998 2,700
1999 4,517
2000 6,216
2001 7,966
2002 9,766
2002 242,591 Net Proceeds of Sale
Internal Rate of Return 13.33
Accumulation of Wealth 276,574
BUY OFFICE BUILDING with refinance proceeds, hold 5 yrs;
YEAR 1998 1999 2000 2001 2002
Initial Investment 150,000
Mortgage Balance EOY 588,764 576,473 563,030 548,326 532,242
YEAR 1998 1999 2000 2001 2002
Net Operating Income 67,500 70,200 73,008 75,928 78,965
Interest Deduction 53,544 52,490 51,337 50,076 48,697
Depreciation 13,884 14,487 14,487 14,487 14,487
Taxable Income 72 3,223 7,184 11,365 15,782
YEAR 1998 1999 2000 2001 2002
Net Operating Income 67,500 70,200 73,008 75,928 78,965
Less Debt Service 64,780 64,780 64,780 64,780 64,780
Cash Flow Before Taxes 2,720 4,517 6,216 7,966 9,766
Income Tax 20 902 2,012 3,182 4,419
Cash Flow After Taxes 2,700 4,517 6,216 7,966 9,766
Analysis of Sale Proceeds EOY year 5
Original Basis 750,000
LessTotal Depreciation 71,832
Adjusted Basis 678,168
Sale Price 850,000
Less Cost of Sale 51,000
Less Adjusted Basis 678,168
Capital Gain 120,832
Capital Gains Tax @ 20% 24,166
Sale Proceeds:
Sale Price 850,000
Cost of Sale 51,000
Less Total Encumbrances 532,242
Proceeds Before Taxes 266,758
Total Tax Liability 24,166
Proceeds After Taxes 242,591
* * *End of Analysis "D" Buy office building"* * *
ANALYSIS "E" Exchange into office building hold 5 years





REALIZED GAIN RECOGNIZED GAIN
Value of Apartments 650,000 Loans Relieved 338,695
Less Adjusted basis 431,818 Less Loans Acquired 477,695
Less Sales Cost 39,000 Net Loans Relief 0
Realized Gain 179,182 Less Other Unlike Property Given 0
Plus Other Unlike Property Received 0
Sum of Unlike Property 0
Recognized Gain 0
Transfer of Basis
Value of Property Acquired 750,000
Less Unrecognized Gain 179,182
Basis in Office Bldg. 570,818

Allocation of Basis in Office Building >
Land 25% 142,705
Improvements 75%428,114

ASSUMPTIONS
Purchase Price 750,000
Mortgage 477,695 Monthly 4,297.95 (9%)
Investment 272,305 (Equity from apartment Building)
Depreciation/Improvements 428,114 39 Yrs, S/L,
Net Operating Income (NOI) 67,500 4% annual growth
Tax Bracket 28%
Capital Gains Rate 20%
Passive Loss Allowance 25,000
New Adjusted Basis 570,818
Sale Price end of yr 5 850,000
Cost of Sale 6%

EXCHANGE APARTMENTS INTO OFFICE BUILDING hold 5 yrs; summary of annual after tax cash flows, detailed cash flow analysis in the sections that follow.
YEAR CASH FLOW
Initial Investment (272,305)
1998 11,906
1999 13,744
2000 15,508
2001 17,330
2002 19,209
2002 318,729 Net Proceeds of Sale
Internal Rate of Return 8.48
Accumulation of Wealth 405,133
EXCHANGE INTO OFFICE BUILDING hold 5 yrs;
YEAR 1998 1999 2000 2001 2002
Initial Investment 272,305
Mortgage Balance EOY 468,749 458,964 448,261 436,554 423,749
YEAR 1998 1999 2000 2001 2002
Net Operating Income 67,500 70,200 73,008 75,928 78,965
Interest Deduction 42,630 41,790 40,872 39,868 38,770
Depreciation 10,520 10,977 10,977 10,977 10,977
Taxable Income 14,351 17,432 21,158 25,083 29,218
YEAR 1998 1999 2000 2001 2002
Net Operating Income 67,500 70,200 73,008 75,928 78,965
Less Debt Service 51,575 51,575 51,575 51,575 51,575
Cash Flow Before Taxes 15,925 18,625 21,433 24,353 27,390
Income Tax 4,018 4,881 5,924 7,023 8,181
Cash Flow After Taxes 11,906 13,744 15,508 17,330 19,209
Analysis of Sale Proceeds EOY year 5
Original Basis 750,000
LessTotal Depreciation 54,429
Less Capital Gain Carried Forward 179,182
Adjusted Basis 516,389
Sale Price 850,000
Less Cost of Sale 51,000
Less Adjusted Basis 516,389
Capital Gain 282,611
Capital Gains Tax @ 20% 56,522
Sale Proceeds:
Sale Price 850,000
Cost of Sale 51,000
Less Total Encumbrances 423,749
Proceeds Before Taxes 375,251
Total Tax Liability 56,522
Proceeds After Taxes 318,729
* * *End of Analysis "E" Exchange into office building"* * *


Let's take a look at how John's MOTIVATION might change the advantages in a Tax Deferred exchange for him. Let's assume that John is fed up with the management responsibilties involved in owning his apartment complex...HE WANTS OUT. John's goal is no longer focused on that office building, instead he is focused on finding a "Replacement" property that will give him the best return as well as potential for wealth accumulation. John discovers an industrial building generating a NNN annual income of $110,000.00 that he can purchase for $1,100,000.00.
ANALYSIS "F" Exchange into industrial building hold 5 years

INVESTMENT BASE ANALYSIS(apartment building)

CAPITAL GAIN

Sale Price 650,000
Less Cost of Sale 39,000
Less Adjusted Basis 431,818
Capital Gain 179,182

PROCEEDS OF SALE
Sale Price 650,000
Less Cost of Sale 39,000
Less Mortgage Balance 338,695
Proceeds Before Tax 272,305
Capital Gain Tax @ 20% 35,836
Proceeds After Tax 236,469 (INVESTMENT BASE)
* * *End of Analysis "F" Investment Base in Apartment building* * *
------------------------------------------------------------------------------------------------------
* * * Analysis "G" Exchange into Industrial Building ***




REALIZED GAIN RECOGNIZED GAIN
Value of Apartments 650,000 Loans Relieved 338,695
Less Adjusted basis 431,818 Less Loans Acquired 827,695
Less Sales Cost 39,000 Net Loans Relief 0
Realized Gain 179,182 Less Other Unlike Property Given 0
Plus Other Unlike Property Received 0
Sum of Unlike Property 0
Recognized Gain 0
Transfer of Basis
Value of Property Acquired 1,100,000
Less Unrecognized Gain 179,182
Basis in Industrial Bldg. 920,818

Allocation of Basis in Industrial Building >
Land 25% 230,205
Improvements 75%690,613

ASSUMPTIONS
Purchase Price 1,100,000
Mortgage 827,695 Monthly 7,446.99 (9%)
Investment 272,305 (Equity from apartment Building)
Depreciation/Improvements 690,613 39 Yrs, S/L,
Net Operating Income (NOI) 110,000 4% annual growth
Tax Bracket 28%
Capital Gains Rate 20%
Passive Loss Allowance 25,000
New Adjusted Basis 920,818
Sale Price end of yr 5 1,487,000
Cost of Sale 6%

EXCHANGE APARTMENTS INTO INDUSTRIAL BUILDING hold 5 yrs; summary of annual after tax cash flows, detailed cash flow analysis in the sections that follow.
YEAR CASH FLOW
Initial Investment (272,305)
1998 15,270
1999 18,237
2000 21,086
2001 24,026
2002 27,057
2002 550,603 Net Proceeds of Sale
Internal Rate of Return 20.86
Accumulation of Wealth 667,818
EXCHANGE INTO INDUSTRIAL BUILDING hold 5 yrs;
YEAR 1998 1999 2000 2001 2002
Initial Investment 272,305
Mortgage Balance EOY 812,195 795,240 776,695 756,411 734,224
PROPERTY INCOME
YEAR 1998 1999 2000 2001 2002
Net Operating Income 110,000 114,400 118,976 123,735 128,684
Interest Deduction 73,864 72,409 70,819 69,079 67,177
Depreciation 16,970 17,708 17,708 17,708 17,708
Taxable Income 19,166 24,283 30,449 36,948 43,800
CASH FLOWS
YEAR 1998 1999 2000 2001 2002
Net Operating Income 110,000 114,400 118,976 123,735 128,684
Less Debt Service 89,364 89,364 89,364 89,364 89,364
Cash Flow Before Taxes 20,636 25,036 29,612 34,371 39,321
Income Tax 5,356 6,799 8,526 10,345 12,264
Cash Flow After Taxes 15,270 18,237 21,086 24,026 27,057
Analysis of Sale Proceeds EOY year 5
Original Basis 1,100,000
LessTotal Depreciation 87,802
Less Capital Gain Carried Forward 179,182
Adjusted Basis 833,016
Sale Price 1,487,000
Less Cost of Sale 89,220
Less Adjusted Basis 833,016
Capital Gain 564,764
Capital Gains Tax @ 20% 112,593
Sale Proceeds:
Sale Price 1,100,000
Cost of Sale 89,220
Less Total Encumbrances 734,224
Proceeds Before Taxes 663,556
Total Tax Liability 112,953
Proceeds After Taxes 550,603
* * *End of Analysis "G" Exchange into industrial building"* * *

If you are considering a tax deferred exchange, be sure to have an Exchange Feasibility Review performed prior to proceeding to the IRS pre-requisite documentation phase.


This analysis prepared by; Stewart L. Mac Donald, CCIM
invest@real-assets.com


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