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1031 Exchange Investing

How Hard Is Your Investment Working

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Assessing Return on Equity

When to sell an investment property depends on many factors, including: the likelihood of future appreciation, the cash flow it produces, the ease or difficulty of managing the property, and the property’s fit in an investor’s overall investment portfolio.

A real estate investor should not overlook a simple measure to determine how hard their invested dollars are working: the property’s Return on Equity.

By analyzing return on equity, a real estate investor can compare a particular property with other potential investments in an effort to maximize the return on their investment equity.

Example: A small quad (4 units) was purchased several years ago on very favorable terms. It produces a nice cash flow that resulted in an extraordinary 20% return the first year. Even with the following assumptions, which would produce a high return on equity, the return falls to less than 5% after 7 years.

  • 10% down payment
  • 90% Loan-to-Value (LTV), 7% fixed mortgage over 30 years
  • Appreciation at an average of 4% per year
  • Annual net income increasing by 2% per year
YearValueDebt (7%)EquityEquity as
% of Value
Annual
Net Income
Return
on Equity
1300,000270,00030,00010.0%6,00020.0%
2312,000267,02044,98014.4%6,12013.6%
3324,480264,06260,41818.6%6,24210.3%
4337,459260,89076,56922.6%6,3678.3%
5350,957257,48993,46826.6%6,4946.9%
6364,995253,842111,15330.4%6,6245.9%
7379,595249,931129,66434.1%6,7565.2%
8394,779245,737149,04237.7%6,8914.6%
9410,570241,241169,32941.2%7,0284.1%
10426,993236,419190,57444.6%7,1683.7%
11444,073231,249212,82447.9%7,3113.4%
12461,836225,705236,13151.1%7,4573.1%
13480,309219,760260,54954.2%7,6062.9%
14499,522213,385286,13757.2%7,7582.7%
15519,502206,550312,95260.2%7,9132.5%
16540,282192,220348,06264.4%8,0712.3%
17561,894191,361370,53365.9%8,2322.2%
18584,370182,934401,43668.6%8,3962.0%
19607,744173,897433,84771.3%8,5631.9%
20632,054164,207467,84774.0%8,7341.8%

As evidenced in the chart above, the investor in this example has a return on equity that starts diminishing significantly after about 7 years of ownership. In order to continue obtaining a much better return on invested equity, an investor should consider exchanging this one investment property after 5-7 years and acquiring multiple replacement investment properties. Later, the investor will benefit again by exchanging these investment properties and exchanging into more (or larger) properties with leverage that will continue to produce a higher return on their equity.

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Dana Ash-McGinty

Principal Broker | Realtor® | “The Real Estate Maven”

Dana Ash-McGinty is the Principal Broker of ASH | MCGINTY, a Washington, DC Real Estate Brokerage. This real estate maven has 15+ years experience in residential, commercial and land sales in addition to multi-state residential renovation, re-zoning, and condo conversion projects. A sought after real estate authority, she has been featured on CNN and in various real estate and financial publications. Dana is married to the highly esteemed Dr. Dana W. McGinty, a Washington, DC based internal medicine physician. They are often referred to as “The Danas”.

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1031 Exchange Investing

What Are The Requirements For A Full Tax Referral 1031 Exchange?

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TAX DEFERRAL AND CAPITAL GAIN CALCULATIONS ARE DIFFERENT

Some real estate investors confuse what is required for full tax deferral in an exchange with calculations involved in determining their accumulated capital gain. The requirements for full tax deferral are different than the capital gain tax and/ or basis computations.

WHAT ARE THE REQUIREMENTS FOR FULL TAX DEFERRAL IN AN EXCHANGE?

If an Exchanger intends to perform an exchange that is fully tax deferred, they must meet two simple requirements:

1. Reinvest the entire net equity (net proceeds) in one or more replacement properties.

AND

2. Acquire one or more replacement properties with the same or a greater amount of debt.

An alternative approach for complete tax deferral is acquiring property of equal or greater value and spending the entire net equity in the acquisition. One exception to the second requirement is that an Exchanger can offset a reduction in debt by adding cash to the replacement property closing.

WHAT IS “BOOT?”

The term “boot” refers to any property received in an exchange that is not considered “like-kind.” Cash boot refers to the receipt of cash. Mortgage boot (also called “debt relief”) is a term describing an Exchanger’s reduction in mortgage liabilities on a replacement property. Any personal property received is also considered boot in a real property exchange transaction.

If the Exchanger receives cash or other property in addition to like-kind property, this may result in a taxable event. To determine the taxes that may be due, several steps are required. First, the Exchanger’s tax advisor must calculate the realized capital gain.

Second, the amount of “boot”, money or other property received, along with any depreciation recapture, must be determined. Finally, a tax advisor should always review the Exchanger’s specific situation to see if there are additional tax issues that may offset any current capital gain tax liabilities.


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