Private Real Estate Investment: Data Analysis and Decision Making_9

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Private Real Estate Investment: Data Analysis and Decision Making_9 185 The Tax Deferred Exchange to justify the cost of an exchange. An interesting empirical study would examine a number of exchanges to determine if perhaps one should not exchange unless one acquires a property at least 1.5 or 2 times the size of the disposed property. Suppose our investor merely retained his original property for the same total time of 12 years. Because he saves mid-holding period sales costs, he has a higher return in both IRR (14.32%) and NPV ($36,314) terms. Note in Figure 7-5 that while the total sales price in the two strategies is greater for the exchange strategy on the left, the owner’s share is greater on the right when no exchange takes place. We see that under these assumptions the primary beneficiary of the exchange is the broker. Several conclusions may be drawn from this. Once again we confirm the fact that pursuing tax objectives for their own sake is counterproductive. Another is that the primary beneficiaries of some exchanges are brokers. Commissions make up the majority of real estate transaction costs. In order to offset these transaction costs, the investor must be able to achieve significant economic gains. There is a limit to the benefits of releveraging via an exchange, and these benefits may not be sufficient to offset transaction costs. DATA ISSUES Data providers sometimes included a binary (Y/N) field to answer the question: Was an exchange involved? This is important when studying Allocation of Sales Proceeds Allocation of Sales Proceeds $2,173,505 $1,760,814 Loan Balance Loan Balance $760,139 $1,228,426 Sale Costs $132,061 CG Tax sts $153,372 Co 2 3 le 3,01 ,03 Sa 16 Equity Reversion 98 Equity Reversion $ x$ $684,032 $715,242 Ta CG (a) (b) FIGURE 7-5 Allocations with (a) and without (b) exchanging. 186 Private Real Estate Investment markets to determine how tax policy affects investor behavior. However, a refinement is necessary. For this data field to have maximum value, it is important to identify how the exchange fits into the transaction. If the sale involved an exchange in which the seller was the last in a series and did not further exchange his property, there is a different effect than if the seller became an acquiring party an a subsequent exchange. Theoretically, there should be a cumulative effect. The last seller who does not require an exchange may reap benefits from each party lower down in the chain, especially if the 45-day deadline is shorter with each successive transaction. There is no reason this must happen, but it should increase pressure in the system as the number of exchanges in a series grows if the deadline does grow shorter. We leave this interesting study to the game theorists. What we suggest is not a trivial task for data collectors. The result of any such effort would be to track transactions after the closing and tie multiple transactions together. This is not an appetizing assignment, and we do not expect it to be completed soon. Until that is done, we will have to rely on theory to study investor behavior in a tax environment that rewards exchanging over sale and repurchase. CONCLUSION After wading through a blizzard of numbers, sorting out complex sub- calculations dependent on other variables, and running a variety of hypothetical situations, there is one conclusion that is neither a surprise nor in doubt: The investor who adds entrepreneurial labor to increase his rate of return and delays his income tax for a long time is able to build terminal wealth faster. For investors where entrepreneurial issues do not apply and annual returns are moderate, the conclusions are less certain. Given the costs, explicit and implicit, the investor who merely plods along with the rest of the economy must be very careful when undertaking an exchange. Scale factors come into play. The size of the acquired property relative to the disposed property strongly influences whether the cost of an exchange can be justified. In our continuing quest to understand real estate risk, exchanging plays a minor role. There is an analogy to the debate over double taxation of corporate dividends. A double taxation policy encourages borrowing, leading to the additional risks in the securities market. For real estate, a sequential taxation policy incrementally taxes each property in a series as it is sold. This encourages more borrowing either for non-taxable refinance and repurchase strategies that reduce investor efficiency by adding multiple locations or for borrowing to keep ownership levels where they would have been if a tax 187 The Tax Deferred Exchange deferred exchange strategy were available. Either of these, while good news for banks, is not good news for society in general if borrowing is seen as adding unnecessary risk to the system. It has been ...