Optimizing Economic Benefit

An optimal exchange strategy delivers the best return on equity to the Exchanger.  Delayed exchanges involve the liquidation of the Old Property and entrusting the resulting cash proceeds to a QI. QIs earn interest on the exchange proceeds they hold. This is the primary means that QIs use to generate income. In today’s interest rate climate, exchange proceeds seldom earn more than 1.75%¹ and QIs typically share very little, if any, of these earnings with the Exchanger. Therefore, earnings on the exchange proceeds that inure to the Exchangor (i.e. return on equity) during the exchange period will be modest at best and probably zero. In general, assets held for income or appreciation are usually providing income or increasing in value.  Hence, to sell such an asset prematurely means that that stream of income or appreciation is stopped when the asset is sold. When lost income and/or appreciation are computed and factored into the overall economics of the exchange, a reverse exchange strategy frequently provides significantly more return on capital to the Exchanger. In a delayed exchange, virtually all of the return on capital goes to the QI. After all, if holding cash were a better investment, nobody would own investment assets.

As an example, one which may be somewhat synthetic and simplistic, consider the following hypothetical situation involving two income-producing investment properties:

Old Property:

• FMV of $2,000,000
• Basis of $1,000,000
• Debt of $600,000 and equity of $1,400,000
• Gross income of $7,000 per month, based on 6% return on equity  
• Monthly depreciation of $1,709 based on the standard real estate assumptions of a 39 year window applied to 80% of the basis
• Assuming a tax rate of 24%, the Old Property generates a net monthly income of $5,730

New Property:

• FMV of $3,000,000
• Equity is transferred from the Old Property and is $1,400,000
• Similar return on equity (6%)  
• Monthly depreciation of $5,128 assuming that the basis of the Old Property will be transferred and that the same depreciation rules apply to the delta between the FMVs of the two properties ($1,000,000)
• Assuming the same tax rate, the New Property generates a net monthly income of $6,551

If a delayed exchanged is used:

• Assume an exchange fee of $750 and interest paid on the exchange proceeds at a rate of 1% while the proceeds are held by the QI.
• Since the Exchangor has relinquished the Old Property and has not yet acquired the New property, there is no net income during the exchange period.
• If the exchange period is 3 months, then the Exchangor will earn a total of $2,750 (3 months of interest at 1% less the exchange fee).

If a reverse exchange is used:

• Assume that the exchange fee is $5,000 and the exchange lasts for 3 months.
• The Exchangor benefits financially from both the Old and the New Properties during the exchange.
• During the exchange period, net income from the Old Property will be $17,191 and net income from the New Property will be $19,652.
• There will be an expense associated with the cost of financing the New Property acquisition (assume $1.4 million in cash taken from accounts bearing interest at 3.5%)
• Also, the Exchangor may not take depreciation on the property held by the Accommodator during a reverse exchange. Accordingly, in an Exchange First, there will be a loss of $1,231 in depreciation benefit and in an Exchange Last, there will be a loss of $3,692.
• Using an Exchange First, net income to the Exchangor during the exchange period will be $18,312.
• Using an Exchange Last, net income to the Exchangor during the exchange period will be $15,901.

This (admittedly synthetic) example shows a fundamental difference between reverse and delayed exchanges: return on equity, the Exchanger’s equity, is kept by the QI in a delayed exchange while it is kept by the Exchanger in a reverse, with the Accommodator earning a fixed fee. The economic disadvantage of turning an investment into cash, even for a short time, can be significant. 

A spreadsheet showing the details of the above example is available by clicking here or by going to Downloads. The spreadsheet is in Excel and can be downloaded. You are free to modify the formulas, if you choose, and enter your own particular numbers to determine which exchange option offers the best economics.  Use this spreadsheet at your own risk!! We assume no responsibility for its applicability to your situation, its accuracy or for the consequences of a decision you make or don’t make based on your use of the spreadsheet. 

 

ExStra never, ever provides tax advice. Please consult your tax professional.
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