End-Game Strategies

Help your clients win when exiting their investments.

Most commercial real estate investors are clear on the benefits of owning income property, but many underestimate the importance of creating an end-game strategy for the timely and favorable disposition of their assets. In fact, many investors today find that their net asset values have grown far beyond estate tax exemptions and now are subject to substantial taxes upon final disposition to heirs. Understanding how to manage these assets is critical to minimizing their tax burdens.

The playing field for calculating investment taxes is complex and uneven. In 2006, the transfer-tax exemption increases to $2 million per person until 2009, when it is scheduled to rise to $3.5 million for the 2009 tax year only. In addition, the Tax Relief Reconciliation Act of 2001 phases out the estate transfer tax in the year 2010 before returning to the pre-2001 structure in 2011. Additional changes in 2001 increased the lifetime gift exemption to $1 million per person and modified the generation-skipping transfer tax exclusion to parallel estate tax exclusions. And many professionals are betting on still more changes to estate transfer tax laws before 2009.

Profiling Your Clients

To successfully advise clients on how to manage their exit plans, commercial real estate professionals should first examine their clients’ investment characteristics. In my experience, most individual investors fall into one of three distinct groups.

Ostriches. Investors in this group keep their heads down and are not interested in going much further than having a will and perhaps a living trust to hold their assets. There is no strategy to provide for the most suitable market timing, deal structure, title entity, asset protection, property management, or liquidation plan. Rather than work with a team of professionals, decisions often are based on the client’s need to react to a situation quickly with little investigation or due diligence. The decision to sell is often in response to outside forces and often when the seller is in the worst position to take advantage of the market.

Blue jays. These investors are interested in keeping -– and spending -– all the marbles in their lifetime. Their objective is to leave nothing to Uncle Sam or other relatives. This group is likely to cash out and pay taxes, especially at the low federal capital gains rate of 15 percent, as soon as the residual, after-tax cash benefit reaches a safe level for funding their life expectancy. Depending on lifestyle choices and the remaining time to play, a number of creative scenarios can be very useful to maximize these investors’ cash flow and preserve their capital.

Eagles. These investors take a long-term visionary approach and are very proactive about their investment real estate portfolio. They generally work with a certified public accountant and attorney as well as a real estate adviser, asset manager, and other professionals. Their goal is to grow the asset value and cash flows while positioning the holdings to benefit future generations of family or favorite charities. They have taken the appropriate steps in choosing the entities and manner of taking title that provide full advantage of the offered tax incentives. This group would be likely to use the personal $1 million lifetime gift exemption to fund a perpetual trust through a liquid liability company and family limited partnership. A favorite qualifying charity ultimately would benefit from a charitable remainder unitrust or charitable annuity trust, while the donor enjoys cash flows for life.

Matching Clients to Strategies

With the above differences in mind, commercial real estate advisers can benefit greatly from keeping their clients abreast of market trends and estate planning tools. The following is a general look at the kinds of exit strategies that investors in all three of these categories may want to consider.

Tax-friendly entities. First and foremost, advise your clients to work with both tax law and accounting professionals to determine their best options for holding title to their property. Some options include family trusts, S-corporations, C-corporations, limited liability companies, limited partnerships, real estate investment trusts, specialized trusts, and family foundations. Choosing the right form of holding title delivers protection of equity, tax savings, and flexibility in planning future benefits.

Tax-deferred exchanges. These tools are the most popular form of putting off the tax man for a future day. While most Internal Revenue Code Section 1031 exchanges are designed to defer all the gain, the exchange also is useful in planning a graceful exit from ownership. A partial exchange results in tax savings for the qualifying portion. The exchange of a large property for several smaller properties allows the investor to spread his tax liability over several tax years. Some things to watch for: Advise clients to take title to the replacement property in the same way they held title on the relinquished property (the time to try out the new entities is before or after the exchange). If the relinquished property closed in the last tax year, investors should not file a return. Instead they should file an extension until closing on the replacement property.

Installment sales. Under Internal Revenue Code Section 453, when the disposition of a property in which at least one payment is to be received after the close of the taxable year in which the sale occurs, the seller will recognize gain or profit as he actually receives the proceeds over time. Typically, the cash down payment would be taxable, net of closing costs, and the remaining installments would be taxed as they are received. This is an effective tax management program with the added benefit of providing interest income for the remaining balance of the contract. Due on sale and prepayment provisions need to be addressed in advance, as the full amount of the remaining tax of gain would be paid in the event the loan is paid off early.

All-inclusive trust deeds. This tool can be particularly beneficial with an installment sale in cases where the existing junior loan carries a lower interest rate than the negotiated rate on the all-inclusive trust deed. The seller then has the arbitrage on the collected rate on the full amount of the combined loans and the lower rate paid on the underlying loans. Existing lenders can be an obstacle.

Lease options. Under the lease option, the title to a property remains with the taxpayer and a contract to sell is contained in an option. The owner of the option leases the property with the lease payment equal to the amount of interest on an installment sale. The lease deposit equals the down payment under an installment sale. The expected benefits to the buyer and seller are that the property taxes would not change; capital gain has not been triggered; the buyer has full use of the property, its management, and cash flow; the seller has lease income, assumes no management, and can plan ahead for the most beneficial year to exercise the option. The Internal Revenue Service, lenders, and the county tax collector all are likely to challenge this device as a hidden sale, so professional counsel is a must.

Exchange for NNN and sell cash flows. This strategy is to complete a 1031 exchange into a quality net-leased investment and borrow against the cash flows at a reasonable discount. The benefits are tax-free cash today.

Family limited partnerships. The formation of a family limited partnership provides a convenient way of passing along equity interests to family members at bargain prices. Control of the property remains with the grantor or general partner and the limited partnership interests are discounted up to 40 percent due to the lack of market liquidity. These can be used with lifetime gift exemptions and generation-skipping plans.

Charitable remainder unitrust. This structure is especially useful when property is fully depreciated. The transfer of ownership to a qualified charity results in no capital gains tax upon sale and cash flow for the life of the donors. The charity receives the remainder of the asset.

Retained life estate. The donor receives a significant tax write-off in the year of transfer and use of the property for life.

Family foundation. This structure provides involvement in funding activities and specific needs, while providing tax benefits and control.

Private annuity trust. Private annuities can provide significant benefit in transferring ownership of assets from one generation to the next. Many rules apply to their application to investment real estate and they are fairly rigid structures that are not easily adaptable after implementation. Many similarities exist between private annuities and installment sales. However, if carefully crafted, private annuities can avoid triggering a taxable event if the related-party obligor decides to sell the property.

Reverse exchange. This is another planning tool that allows the replacement property to be acquired prior to closing on the relinquished property. Recent tax rulings have blessed this strategy, but it is best to work with an experienced accommodator. In some circumstances related entities can be useful in completing a qualified exchange.

Exchange with tenants in common. Often this is an exchange in which management-weary owners acquire a tenancy in common in a larger property with professional management. This also is a strategy in which related entities (for example, a family trust and a corporation) each can acquire a portion of the equity in a replacement property, limiting the percentage of ownership in the trust subject to the old basis and “bookmarking” with the corporation a portion of the equity for future exchanges. Related-party rules apply in this scenario, requiring that the related entity must not dispose of the property for 24 months.

Umbrella partnership real estate investment trusts. An UPREIT is an exchange in which equity in a property or portfolio of properties is relinquished for shares in a real estate investment trust. This usually applies to larger and newer properties that would fit a REIT acquisition profile. Limitations apply to the sale of the newly acquired stock.

Corporate conversion to REIT. In June 2001 the IRS issued Revenue Ruling 2001-29 in which corporate-owned real estate can be transferred tax free to a corporate shareholder’s stand-alone business subsidiary. The subsidiary then can elect to be treated as a REIT and lease the property back to the corporation in an arm’s-length transaction.

Offshore trusts. Offshore enterprise zones can offer special benefits under some circumstances. Consult a very specialized tax attorney or CPA to navigate these safe havens.

Redevelopment area joint venture. Owners of property in a redevelopment area may find benefits in structuring a joint venture with a reliable development firm. Care should be taken to preserve long-term capital gains treatment.

Combine IRC 1031 and 121. This new IRS Revenue Procedure went into effect Feb. 14, 2005. When a seller has owned and lived in a home for two of the past five years, it is eligible for the capital gain exclusion under IRC 121, even if it is presently being used as a rental. For a married couple this could result in an exclusion of $500,000 in tax-free cash and a deferral of the balance of the gain under IRC 1031.

While this is not an all-inclusive list of strategies, qualified professionals in each specialty, practice, and worldwide location can be reached for further information through the CCIM Partners program at Qualified charitable contributions as well as questions for more information can be directed to the Education Foundation of the CCIM Institute at

Chuck Wise, CCIM

Chuck Wise, CCIM, is president of Wise Investment Properties, Inc., in Encinitas, Calif. Contact him at (760) 224-9000 or


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