Strategizing your real estate future: The decision to refinance or sell using a 1031 exchange - by Chris Macomber

Chris Macomber, StonehamBank

Oftentimes, a commercial loan customer will approach me and ask, “What should I do when my commercial real estate loan balloon payment is due in the upcoming months?” Typically, commercial real estate loans are written with a ten or fifteen year term and a twenty or twenty-five year amortization. The difference in the loan term and loan amortization causes a lump sum payment of loan principal due at the end of the loan term, commonly referred to as the balloon payment.

One option for the real estate investor to address the balloon payment is to refinance the mortgage at prevailing rates. A visit with their bank’s loan officer will provide them with current loan interest rates and terms summarized in a loan term sheet. It is important for the investor to obtain a loan term sheet from the Bank’s Loan Officer so it can be shared with other advisors and used for comparison with other options. A second option available to the investor is to sell their property and utilize a 1031 exchange for the purchase of another investment property. When the balloon payment due date approaches, these two options should be considered by the real estate investor.

Alan Fruitman, author of The Triple Net Property Book and founder of 1031tax.com states that a 1031exchange is a section in the internal revenue code that allows an investor to sell an investment property and purchase another investment property while deferring all taxes related to the sale. Fruitman explains there are four reasons an investor should consider a 1031 Exchange: • Deferment of Capital Gains and Depreciation Recapture Tax; • Consolidation of investment properties; • Diversification of rental properties; and • To simplify an investor’s life.

The value of the 1031 Exchange Fruitman described above differs from the value to the investor when compared with a straight refinance of the existing loan. Fruitman is a proponent of having investors assess their real estate to see if their properties pose a problem to future investment goals. If the answer is yes, then Fruitman explains a 1031 Exchange could provide value. According to Fruitman an investor could defer taxes, consolidate a large real estate investment portfolio, diversify the portfolio, or become a passive real estate investor with a triple net lease property.

The process of making an informed decision regarding the use of  a 1031 Exchange involves several key players of a real estate investor’s team. James Connors, senior vice president at Boston Financial Partners Group, LLC recently discussed that deferring a cash outlay of taxes is a great benefit for his clients to take advantage of other investment opportunities. Connors also has seen clients have success in acquiring investment properties at a discount, leveraging the seller’s 180 day timeframe constraint inherent in the 1031 Exchange. The 1031 Exchange, according to Connors, can act as a tool to help facilitate a real estate transaction offering tax benefits for the seller and price benefits for the buyer.

Eric O’Brien, president of O’Brien Commercial Real Estate Brokerage comments that the investor should emphasize the value of the real estate deal over the 1031 Exchange’s benefits. O’Brien has seen the 180 day timeframe force investors to purchase less than ideal property. As a result, the property didn’t have great cash-flow and took the investor years to unload.

George Vallas, CPA and partner at Valles & Arrison, PC observed a longer term perspective on 1031 Exchanges. Vallas said,“They are great now, but when done repeatedly, they can lead to very expensive property with minimal to no basis that will eventually be sold, not exchanged, and will result in nearly 100% proceeds being recognized as a gain.”

Investors are faced with decisions when the loan balloon payment is due. The first question to be answered when the loan balloon payment is due is what would a new mortgage at current market rates and terms look like? An assessment of the property to see if it is still fits future investment and lifestyle needs should answer the investor’s second question; should I sell the property? A definite long-term goal should be articulated before embarking on the process of utilizing a 1031 Exchange. A team of advisors should examine the 1031 Exchange’s effects on the investor’s portfolio and offer their opinions regarding the 1031 Exchange’s fit with the investor’s overall objectives.

Chris Macomber is vice president for business development at StonehamBank, Stoneham, Mass.