The Best-Kept Secret in Private Real Estate: A 1031-Exchange Case Study

Author: Sam Eaton, Director Of Investor Relations

Investors today have more options than ever before in terms of choosing a real estate sponsor with whom to invest in private deals. More than any other single characteristic, Timberland Partners stands apart from the competition because of the long-term nature of the investments. This choice is deliberate.

Where a single acquisition may prove to be a great investment, the real secret is that long-term owners who utilize tax-advantageous strategies such as a 1031-Exchange (or a refinance) at the time of a loan maturity capture the most value.

Capitalizing on these opportunities does not compensate for a poor initial investment, but it can greatly enhance returns compared to the alternative – a liquidating sale – whereby a long-term capital gains tax is paid, rather than deferred.

Though this concept is widely accepted, the value of compounding pre-tax dollars remains significantly underappreciated. We’ll illustrate with the example of a recent sale and Exchange within Timberland Partners Apartment Fund IV, and compare this to a hypothetical sale and purchase of the same properties on an after-tax basis.

Fund IV purchased Village I in Lawrence, KS, in September 2016 for $6,000,000. The equity that the Fund invested was $1,335,000. The property offered potential upside in revenue from light unit renovations, and greater operational margins by implementing our in-house property management. In May 2018, the Fund sold the property for $9.4 million – a 52% increase over the purchase price. Equity proceeds totaled $4,090,000, a 42% internal rate of return (IRR) on the investment of $1,335,000. 

A liquidating sale would have triggered a capital gain of $3,600,000, resulting in a tax of $1,260,000 assuming a combined federal and state rate of 35%. The sponsor of the Fund had the choice to either reinvest (Exchange) the full $4,090,000 into another property and defer capital gains taxes, or distribute the proceeds to the partners, leaving them with $2,830,000 net of their tax obligation.

The sponsor chose to complete a 1031-Exchange and found a suitable replacement property in Norman, OK. The $4,090,000 invested equated to a 47.72% interest in the property. As of March 2021, the value of Fund IV’s equity in this property was in excess of $4.8 million, a compound annual growth rate of over 10% since the Exchange. In addition, the Fund has received $357,900 in cash flow distributions from the property.

As a comparison, had the partners invested their after-tax proceeds of $2,830,000 into the same property in Norman, OK, it would have equated to a 28.97% interest in the property after a dilution for the carried interest of the sponsor (as any initial investment would incur). In March, 2021, that interest would have been worth $2.96 million, a full $1.84 million less than the value above using tax-deferred (Exchange) proceeds. Further, because of the reduced ownership interest, the cash flow distributions under this scenario would have been $217,218 – a decrease of $140,682 compared to the tax-deferred scenario. Taken only to this point, the value of completing the Exchange far exceeds the value of the liquidating and reinvesting scenario.

Of course, the capital gains tax obligation on the Exchange interest was only deferred, not eliminated. A true comparison must show these two alternatives both on an after-tax basis assuming a full liquidation of the replacement property today. The chart below walks through a side-by-side comparison for the value in the Exchange as it was actually completed, versus investing after-tax dollars in the same property.

Two key pieces stand out.

First, in the Exchange scenario, even though the eventual tax obligation on liquidating the interest in the Norman property was $1,793,116¹ (454% higher than the liquidating sale/reinvesting scenario), because of the higher ownership interest in the property, the post-liquidation equity net of tax was $3,080,888². This is a full $446,132 greater than the Liquidating Sale/Reinvesting Scenario.

Second, because of the initial tax and the additional dilution to the sponsor, the difference in ownership interest in the Norman property was 18.76% less in the Liquidating Sale/Reinvesting Scenario than in the Exchange scenario. Over the three years the Norman property has been owned, it has paid out only $750,000. Yet that 18.76% additional interest equated to a sacrifice of $140,682³ of the $750,000 in total distributions.

Between the forfeited equity value and the forfeited distributions, the total value sacrificed by not executing the Exchange was $586,814 – a 20.6% loss on an after-tax basis. In other words, that is the value left on the table by not participating in the Exchange.

The upside of participating in the Exchange is, in most cases much higher even than this.

Here’s why: 

1. First, while growing nicely in value, the Norman property has not met the initial cash flow expectations of Timberland Partners, as distributions have averaged below 4% on an annual basis since acquisition. To the extent that the property produced distributions in the 7-10% range paid in most of our investments, the additional value sacrificed by the 18.76% reduced interest in distributions would have been that much greater.
2. Second, in this model, no additional value was given to the $140,681 in distributions from Norman in the three years of ownership. That is to say, it assumes these dollars earned nothing once distributed to the investor. To the extent they were invested and earned a positive return, the total value sacrificed to the Exchange would be that much greater.
3. Lastly, this model assumes a liquidating sale in the second property only to illustrate the power of pre-tax compounding regardless of timeline. In reality, capital gains tax is only paid when the partnership interest is finally liquidated. Therefore, a significantly larger benefit exists for those investors who hold their interest until the time of death. Current tax law allows the investor’s beneficiaries to step up the basis in the investment to the fair market value as of the date of death. A sale at this time then eliminates the beneficiary’s capital gain tax. This may be the most powerful strategy available to investors wishing to transfer wealth to future generations.

The reality is that for most investors, the chance of taking after-tax proceeds, reinvesting and outperforming Exchange proceeds is extremely low. If the goal is to maximize wealth, the first choice should be to defer tax obligations. When considering investing with a sponsor whose offering plans a liquidating event after the first investment, ask if that decision is for your benefit as an investor, or for their benefit as the sponsor.