Our most recent webinar discussed ways to divide commercial real estate in property settlements. In it, long-term partner at leading law firms Jonathan Black of Essex Realty Investments LLC and AACFL board member and faculty Lee Sanderson of Valuation Forensics featured an effective tax-free method.
Usually a primary marital asset, commercial real estate must be sold to fund a divorce settlement. As part of the negotiations, Mr. Black emphasized that if a property hasn’t been sold, some family courts may value the settlement without considering the after-tax treatment or effects. The owner could then end up paying as much as 50 percent of the property value without a reduction for the taxes due upon its sale. Oftentimes, the payor has held the property for a while, which means that it has been depreciated and has little to no cost basis (the original property value adjusted for depreciation and other factors).
Depreciation expenses lower the cost basis. If your client sells a property, they pay back some of that deduction, or recapture, in taxes. If they owned the property for at least a year and sold it for a profit, they may also pay long-term capital gains tax tied to the depreciation recapture.
Generally, the investor pays a high settlement fee and taxes and suffers a major loss. To save your clients money, turn their marital commercial properties into cash, prevent tax debt, and ensure a smooth settlement, Mr. Black suggested effective planning with a “cash-out exchange.”
How Does a Cash-out Exchange Work?
Mr. Black showed examples of divorce settlements that involve commercial real estate with and without a cash-out or tax-free property exchange.
In the fictional scenario, a man named Taylor owns $20 million in commercial real estate at fair market value. As a New York state taxpayer, he bought the property for $10 million and has held it for several years. Therefore, it has a no-cost basis. Neither Taylor nor his spouse has a mortgage on it.
The divorce settlement results without the cash-out:
- After the property sale, taxes and depreciation, and the divorce settlement, Taylor nets only $1.7 million.
- As part of New York equitable distribution laws, the payee spouse receives half the property value, $10 million, tax-free.
- Taylor also pays $8.2 million in taxes, which upsets him about his unfair loss, the divorce planning, and those involved in it.
The aftermath with the cash-out exchange:
The cash-out exchange creates a “win-win” solution for both parties. It reduces the settlement obligations, funds the settlement, and removes tax liabilities.
Based on the tax law for “like-kind” exchanges, in this scenario, Taylor’s cash-out exchange creates tax-free liquidity of up to 65 percent of the property value. A “like-kind” or 1031 exchange allows for the tax-deferred disposal of real estate and the acquisition of a replacement asset.
In this scenario:
- Taylor and his spouse agree to divide the cash-out proceeds and interest in the new property 50/50. They each get $6.5 million from the exchange tax-free.
- They also receive a yield, or “cash on cash” return of $175,000 yearly, on their carried interest on the replacement property ($3.5 million).
Our webinar offers a detailed, itemized list of the hypothetical fees involved in both examples.
More About How Cash-out Exchanges Can Help You and Your Clients
As you can see, you save your clients tons of money, limit settlement amounts, and eliminate their tax payments, which helps them live “happier ever after.” Both ex-spouses can move forward, and as they age, they will earn passive cash flow.
The webinar also addressed attendees’ comments and questions. Among the questions Mr. Sanderson and Mr. Black answered were:
- What happens if Taylor and his ex-wife hold the property jointly?
- How do you handle “like-kind” exchanges for clients who don’t own as much property versus those who hold triple-net exchange real estate?
- When the payor spouse dies, will there be huge capital gains and estate tax hit?
- Does the payee spouse incur debt from the exchange?
- How do you sell this concept to a non-earning spouse and their lawyer?
As Mr. Black explained, overall, you should plan for cash-out exchanges – they involve meeting time-frames and working with a court. You want to make sure you handle them correctly for a favorable outcome. Mr. Sanderson said he often uses them in his business, and as one of his favorite tax structures, they create an equitable financial result.
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