Investors Section

1031 exchanges
Material courtesy of Realty Exchangers at http://www.irs1031exchanges.com/ProcedureManual.shtml


A tax deferred exchange allows us to sell a piece of investment (i.e. rental), trade or business property, buy a new property with the gain or profit from the sale, and not owe taxes on the sale immediately. If you eventually sell the new piece of property, you would owe taxes at that time. Generally, all gains and losses on sales of real estate are taxable, but an exception lies where the property sold is traded or exchanged for "like-kind" property. The new property is seen as a continuation of the original investment, so taxes are not due at the time of the sale.

Many people view tax deferred exchanges as being for huge corporations, or only for professional investors. I believe that everyone should take advantage of these where they can. Strategy -- purchase a rental home below market value, rent it for a year, sell it, and buy two rental properties with your gain. Note that if you do this too many times, the IRS may take the view that you are not a long term investor, and disallow such exchanges. When you get ready to do a tax-deferred exchange, you will need the services of a qualified CPA or Attorney. This is a basic introduction only, and you should always get professional advice from someone who has all the details on your deal, since so much liability is at stake. In my course I list the company that I use for these real estate exchanges. They are a national company and can help you out wherever you are in the country. I have used them for several deferred exchanges, and they have been an excellent resource and extremely competent.

Let's look at how one of these deals would work. Assume that you own a rental property that has gone up in value. You'd like to sell this property and then reinvest the proceeds into some other rental real estate. You can avoid the tax bill if you can find suitable property to exchange for. The difficulty of the tax deferred exchange is that the property you are going to purchase must be identified within a certain amount of time, and it must be closed within a certain amount of time after it is identified. Unfortunately, no extensions are possible.

Identifying Property

You must identify property in a written document signed by you, and delivered to the party assisting you with the exchange (cannot be related to you!) on or before 45 days from the date you sold the original rental property. There is a growing body of support for identification of properties, and closing of new properties before the original property is sold. This is somewhat controversial and outside the scope of this discussion.

Technical Note: You can identify more than one property as the replacement property. However, the maximum number of replacement properties that you may identify without regard to fair market value is three properties. You may identify any number of properties provided that the total value of these properties is not more than 200% of the value of the original property you are selling. Note that you don't have to close on all the properties you identify. You can name several if you're not sure what will close, or not close, but you have to observe the rules in this technical note in terms of the value of properties you identify. If at the end of the identification period you have identified more properties than you are allowed, you are generally treated as if no property was identified. This means that you pay taxes!

Time Limits For Completing the Exchange

If you have correctly complied with the identification phase of the exchange, you have up to 180 days to complete an exchange, but the period may be shorter. Specifically, property will not be treated as like kind property if it is received more than 180 days after the date you transferred the property you are relinquishing, or after the due date of your return (including extensions) for the year in which you made the transfer.

For multiple property transfers, the 45 day identification period and the 180 day exchange period are determined by the earliest date a property is transferred.

Avoid Boot!

Boot is defined as any money or any type of property of unlike kind (example, a car received as part of down-payment). You will be taxed on this boot regardless of whether or not you carry out the exchange correctly. You will want your exchange company, or attorney to examine your transaction closely to make sure you don't receive anything that could count as boot. Special rules apply for exchanging property with assumed mortgages.

Summary

The tax-deferred exchange is a great way to maximize your wealth. By keeping your investments growing without immediately paying taxes, you can do wonders for your net-worth. You will need to search out a good intermediary. I am happy to provide the name of mine for our members. This may seem like a dry subject, but it is important to understand when you begin to accumulate some rental properties.

Remember that this article is to provide basic information only. If you are planning on doing a tax deferred exchange, you really need to speak with a professional that handles these transactions on a regular basis. Information here is subject to change by IRS regulations or statute, so be sure to use current information provided by your accountant or other professional when planning a strategy involving tax deferred exchanges.

 

Real Estate Investment Analysis Formulas

Income and Expense Statement

Income

Potential Gross Income (PG1) $__________

Less: Vacancy and Bad Debt Allowance __________

Equals: Effective Gross Income (EGI) $__________

Operating Expenses

Exclude: Depreciation

Mortgage Payments

Non-Operating Expenses. E.G Directors Salaries

Capital Expenditures $__________

Net Operating Income (NO1) __________

Less: Debt Service (P + I) __________

Cash Flow Before Tax (CFBT) __________

Less: Income Taxes __________

Equals Cash Flow After Tax (CFAT) $__________

Financial Measures:

Potential Gross Income Multiplier (PGIM)

Also called Potential Gross Rent Multiplier(PGRM)

PGIM = Market Value or Market Value = Potential Gross Income x PGIM

Potential Gross Income

MV = EGI x EGIM

= MV

PGI

Effective gross Income Multiplier (EGIM)

Also called Effective Gross Rent Multiplier(EGRM)

EGIM = Market Value or Market Value = Effective Gross Income x EGIM

Effective Gross Income

MV = EGI x EGIM

= MV

PGI

Net Income Multiplier (NIM)

NIM = Market Value or Market Value = Net Operating Income x Net Income Multiplier

Net Operating Income

MV = NOI x NIM

= MV

NOI

Capitalization Rate (Cap Rate)

Also called Broker’s Yield

Cap Rate(%) = Net Operating Income x 100 or Market Value = Operating Income x 100

Market Value Cap Rate(%)

= NOI x 100 MV = NOI x 100

MV Cap Rate(%)

Return on Equit y(ROE)

Also called: Equity Dividend Rate(EDR)

Cash on Cash Return

ROE(%) = (Net Operating Income – Debt Service) x 100

Equity

Where: Equity = Market Value – Mortgage

Debt Service = Principal & Interest Payment or MV = (NOI-DS) x 100 + Mortgage

ROE(%)

ROE(%) = Cash Flow Before Tax x 100

Equity

ROE(%) = (NOI–DS) x 100

(MV–Mtge.)

Default Ratio (Break-even) (%)

Using Potential Gross Income Using Effective Gross Income

= (Operating Expenses + Debt Service) x 100 = (Operating Expenses + Debt Service) x 100

Potential Gross Income Effective Gross Income

Financing Measures.

Debt Service Ratio (DSR) Loan to Value Ratio (%)

= Net Operating Income = Loan Amount x 100

Debt Service Market Value

Rental Apartment Building Measures.

1. Price Per Suite

2. Price Per Sq. Foot (Using Suite Areas)

3. Rents Per Sq. Foot per month

4. Operating Costs

a. Operating Costs Per Suite Per Year

b. Operating Cost per Sq. Foot per Year

5. Operating Expense Ratio (OER) = Operating Expense x 100

Effective Gross Income

Home Financing:

Gross Debt Service Ratio = (Principal + Interest + Taxes)

Gross Family Income

Lenders often modify the basic Gross Debt Service Ratio Formula.

Modified Gross Debt Service Ratio = (Principal + Interest + Taxes + Heat + % of Maintenance

Gross Family Income

Total Gross Debt Service Ratio = (Principal + Interest + Taxes + Other Debt Payments)

Gross Family Income

Commercial Real Estate Sample Calculations

The following examples illustrate how to use the real estate formulas. In Example No.1 the information is obtained for the property and

the financial measures calculated. In Example No. 2 the financial measures such as the Cap Rate are obtained for comparable sales and

are used to calculate the Market Value for the subject property.

Example No 1.

Sale Price (Market Value) $3,165,000

Potential Gross Income: $306,000

Vacancy & Bad Debt Allowance: 4.5%

Operating Expenses $58,000

Mortgage $2,056,000

Mortgage Payment (P+i) $180,538

Number of Suites 30

Total Rentable Area 24,000 Square feet

Note: All figures are annual

Calculate: Potential Gross Income Mulitplier (PGIM)

Effective Gross Income Multiplier (EGIM)

Net Income Multiplier (NIM)

Capitalization Rate (Cap Rate)

Return on Equity (ROE)

Default Ratio (Break even) based on:

Potential Gross Income

Effective Gross Income

Debt Service Ratio (DSR)

Loan to Value Ratio

Price per Suite

Price per Square Foot

Rent per Square Foot per Month

Operating Cost per Suite per Year

Operating Cost per Square Foot per Year

Operating Expense Ratio (OER) based on:

Potential Gross Income

Effective Gross Income

1. Construct an Annual Income and Expense Statement

Potential Gross Income $306,000

Less Vacancy & Bad Debt Allowance (4.5%) 13,770

Effective Gross Income $292,230

Operating Expenses 58,000

Net Operating Income $234,230

Less; Debt Service (P+i) 180,538

Cash Flow Before Tax $ 53,692

2. Calculate the Financial Measures

Potential Gross Income Multiplier (PGIM):

PGIM = MV = 3,165,000

PGI 306,000

= 10.34

Effective Gross Income Multiplier (EGIM):

EGIM = MV = 3,165,000

EGI 292,230

= 10.83

Net Income Multiplier (NIM):

NIM = MV = 3,165,000

NOI 234,230

= 13.51

Capitalization Rate (Cap Rate):

Cap Rate = NOI = 234,230 x 100

MV 3,165,000

= 7.40%

Return on Equity (ROE):

ROE = (NOI – DS) x100 = Cash Flow Before Tax x 100

EGI Equity

= 53,692 x 100

(3,165,000 - 2,056,000)

= 4.84%

Default Ratio (Breakeven):

Based on Potential Gross Income:

Default Ratio = (Operating Expenses + Debt Service) x 100

Potential Gross Income

= (58,000 + 180,538) x 100

306,000

= 77.95%

Default Ratio (Breakeven) cont.

Based on Effective Gross Income:

Default Ratio = (Operating Expenses + Debt Service) x 100

Effective Gross Income

= (58,000 + 180,538) x 100

292,230

= 81.63%

Debt Service Ratio (DSR) = Net Operating Income

Debt Service

= 234,230

180,538

= 1.30

Loan to Value Ratio % = Loan Amount x 100

Market Value

= 2,056,000 x 100

3,165,000

= 64.96%

Price Per Suite = 3,165,000

30

= $105,500

Price per Square foot = 3,165,000

24,000

= $131.88

Rent Per Sq. Foot per Mo. = 306,000

24,000 x 12

= $1.06

Operating Costs Per Suite Per Year

= 58,000

30

= $1,933

Operating Cost per Square foot per year

= 58,000

24,000

= $2.42

Operating Expense Ratio (OER)

Based on Potential Gross Income:

= Operating Expenses x 100

Potential Gross Income

= 58,000 x 100

306,000

= 18.95%

Based on Effective Gross Income:

= Operating Expenses x 100

Effective Gross Income

= 58,000 x 100

292,230

= 19.85%

Summary.

Potential Gross Income Multiplier (EGIM): 10.83

Potential Gross Income Multiplier (EGIM): 10.83

Net Income Multiplier (NIM): 13.51

Capitalization Rate (Cap Rate) 7.40%

Return on Equity (ROE) 4.84%

Default Ratio (Break even) based on:

Potential Gross Income 77.95%

Effective Gross Income 81.63%

Debt Service Ratio (DSR) 1.30

Loan to Value Ratio 64.96%

Price per Suite $105,000

Price per Square Foot $131.88

Rent per Square foot per month $1.06

Operating Cost per Suite per Year $1,933

Operating Cost per Square Foot per Year $2.42

Operating Expense Ratio (OER) based on:

Potential Gross Income 18.96%

Effective Gross Income 19.85%

Example No 2.

Potential Gross Income: $244,800

Vacancy & Bad Debt Allowance: 5.0%

Operating Expenses $49,300

Mortgage $1,685,000

Mortgage Payment (P+i) $147,500

Number of Suites 24

Total Rentable Area 18,720 Square feet

Note: All figures are annual

Calculate the Market Value using the following financial measures

Effective Gross Income Multiplier (EGIM): 9.30

Net Income Multiplier (NIM): 12.50

Capitalization Rate (Cap Rate): 8.00%

Return on Equity (ROE): 5.57%

1. Start by constructing the Annual Income and Expense Statement

Potential Gross Income $244,800

Less Vacancy & Bad Debt Allowance (5.0%) 12,240

Effective Gross Income $232,560

Operating Expenses 49,300

Net Operating Income $183,260

Less; Debt Service (P+i) 147,500

Cash Flow Before Tax $ 35,760

2. Calculate the Market Value based on the:

Effective Gross Income Multiplier (EGIM):

MV = Effective Gross Income x EGIM

= 232,560 x 9.30

= $2,162,808

Net Income Multiplier (NIM):

MV = Net Operating x NIM

= 183,260 x 12.50

= $2,290,750

Capitalization Rate (Cap Rate):

MV = Net Operating Income x 100

Cap Rate

= 183,260 x 100

8.0

= $2,290,750

Return on Equity (ROE):

MV = (NOI - DS) x 100 + Mortgage

ROE

= (183,260 - 147,500) + 1,685,000

5.57

= $2,327,011

 

 

Fixer uppers


Ask many a home buyer about the type of house they are looking for and many will reply "We are looking for something we can fix up and live in (or resell). We like the idea of gaining some quick sweat equity." The classic "fixer-upper" home. Unfortunately, there is a bit of fantasy in the notion, though. First of all, there are many more fixer-upper buyers than there are fixer-upper properties. Second, the current thinking in many minds is that anyone can make a killing in the Real Estate market, which is not always the case. Third,
many buyers totally mis-estimate both the cost and the time involved in fixer-uppers, severely impacting (and in some cases destroying) the profit potential. Unless you are fully prepared to deal with the realities of fixer-uppers rather than the fantasies, it probably is a good idea to look elsewhere for a home.

This does not mean that there isn't equity to be gained (or profit to be made) by purchasing the RIGHT property at the RIGHT price. The important notion is to understand that there are several factors that will make the difference between winning and losing in such a transaction.

The Mindset

The first factor that must be understood is that it isn't going to be easy. The only people who think that finding, buying, fixing and selling a home is an easy task are those who have never done it. Those with any experience (even if only once) will tell you that it rarely is as simple as it appears. In general, it is best to assume that repairs will cost twice what you estimated, take double the amount of time and,when finished, the house will be worth less than expected. If you keep that in the forefront of your thinking, the chances of being burned are much less.

Foreclosure sales are often good sources for fixer-upper properties. A couple of resources that specialize in listings of those types of homes are and . All three of the resources above offer free trial periods to evaluate their services and search for foreclosure listings in the area in which you are interested.

Start Out Small

Some of the worst examples of mistakes made by buyers of fixer-uppers are first-time buyers who bite off way more than they can chew. Examples of this are houses that have structural problems or will take an exceptionally long time to repair, or are located somewhere other than a desirable neighborhood. These can be a horrible drain on finances, time and peace of mind.

A much better strategy for the inexperienced is to purchase a home in a desirable neighborhood that is in need of cosmetic attention--new paint, carpeting, appliances, landscaping and the like. These repairs can either be handled by the homeowner or are easily contracted out, saving time, effort and money. Yes, money can be made on homes needing major renovations, even if they
are in less popular neighborhoods, but these are jobs for professionals, not homeowners (and definitely not for first-time homeowners!)

Avoid Surprises

The most expensive situations are often those that are the least expected--those nasty little (and often big) surprises that jump out at you. You can avoid many of these surprises, though, with a couple of easy steps taken BEFORE final commitment to a property.

1) Have the property thoroughly inspected. Have the inspector detail all obvious (as well as potential) defects in the property. NOTE: The seller may say "we are selling the house as-is, so NO inspections." Avoid this property like the plague.

2) Run the numbers. You must know the market values for houses in the neighborhood in which you are interested that need no repairs. Running the numbers means working them backwards to see how much equity or profit may be available (or even IF there will be any) in the deal. You will need to begin by computing the realistic value of the home when all repairs are made. From that point, you will need to subtract any selling expenses you will incur (commissions and the like) as well as the full cost of repairs and, most importantly, the amount of desired profit or equity.
Example:

$600,000: Expected Sale Price, Repaired
-40,000: Selling Expenses
-25,500: Repair Expenses
-50,000: Desired Profit/Equity
$485,000: Maximum Property Purchase Price

Don't be deluded into thinking that you'll be able to sell for more than the market value or do the repairs for less than the estimates. If the numbers don't fit--with a good amount of "wiggle room" for more expense or handling costs or if the property does not sell quickly--don't waste your time or your money!

Summing Up

When considering a fixer-upper, whether for resale or to live in with increased equity, go into the process fully prepared so you will avoid many surprises. For your first project, only consider structurally sound homes in good neighborhoods requiring cosmetic repairs only. Have any property you are considering fully inspected and then get firm estimates for all needed repairs. Most importantly, "run the numbers" to be certain that the potential for gain is truly there. If you are satisfied on all counts, you may very well be able to be successful with your fixer-upper project “Remember not making a decision is still a decision!

Short sales

Overview on Short Sales and Foreclosures
The Basics of “Short Sales”
by William Bronchick

You will likely come across dozens of properties in foreclosure with little or no equity, that is, the seller owes at close to or more than the property is worth. In these situations, lenders are sometimes willing to accept less than the full amount due, commonly referred to a "short pay" or "short sale."

Negotiating a short sale with the lender is a difficult process, generally because it is a daunting task finding a bank officer who has the authority to accept a discount. You will have to call around to locate the lender’s “Loss Mitigation Department.” More than likely, each lender you deal with will have a separate name for this department, so be patient when calling. Much like getting your phone bill corrected, you can expect the process to involve a lot of waiting on hold and being bounced around an intricate maze of automated voice mail systems. Once you get in touch with the right person, then the negotiating begins.

From the lender’s perspective, a short sale saves many of the costs associated with the foreclosure process - attorney fee's, the eviction process, delays from borrower bankruptcy, damage to the property, costs associated with resale, etc. In a short sale scenario, the lender gets the property back faster, so it is able to cut its losses. Your job as the investor is to convince the lender that it will fare better by accepting less money now.

The lender will want some information about the property, the borrower and the deal he has made with you. Specifically, the lender wants to know what the property is worth. The lender will generally hire a local real estate broker or appraiser to evaluate the property (called a broker’s price opinion or “BPO”). You can also submit your own appraisal or comparable sales information. In addition you will want to offer as much specific negative information about the property as possible. Also, include some relevant information about the neighborhood and the local economy if things are bad (copies of newspaper articles with “bad news” may help). A contract’s bid for repair estimates should also be submitted, which, of course, should be the highest bid you can obtain!

The lender will also ask for financial information about the borrower. Sort of a backwards loan application, the borrower must prove that he is broke and unable to afford the payments. The borrower must show that he has no other source of income or assets to repay the loan. This process may involve as much, if not more paperwork than an original mortgage application! The borrower should submit a “hardship letter”, which is basically a sob story about how much financial trouble the borrower is in. This may require a little literary creativity, and some help on your part. Don’t lie, just paint a picture that doesn’t look good.

Finally, the lender generally wants to see a written contract between you and the seller. The lender wants to make sure the seller isn’t walking away with any cash from the deal. Generally, the contract must be written so that the buyer pays all costs associated with the transaction, so that the “net cash” to the seller is the exact amount of the short pay to the lender. A preliminary HUD-1 settlement statement is often requested, which can be difficult, since many title and escrow companies simple won’t prepare one in advance of closing. You can prepare your own HUD-1, and simply write “preliminary” on the top.

Don’t be surprised if your short sale bid is rejected. Lenders aren’t emotionally attached to their properties, so they aren’t as likely to give you “steal.” Many short sales fall through if the BPO comes in too high, which is often the case. You can’t pull the wool over a lender’s eyes - if the property isn’t is need of serious repair, it is unlikely you can convince the lender the property is worth a whole lot less than the appraised value.

If you are interested in these properties please contact me and I can furnish you a list of properties

 

Mailand Realty
2715 N. Harbor City Blvd. Suite 4 • Melbourne, FL
Phone: (321) 253-0733 • FAX: (321) 253-0731
Copyright © 2007

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