Dr. Morgan has owned the 10 thousand square foot strip center at the corner of Cornell and Baseline in Portland for 20 years. His father helped him buy it and over the years deeded his interest to the good doctor. His kids are all grown and done with college. He sees himself working until he is 65. Now at 60 years of age the doctor needs to make a decision: to sell or not to sell?

His phone was ringing off the hook. Real Estate brokers were calling him every day quoting sales prices that were off the charts, close to $240 a foot or $2,400,000 dollars. He and his father had bought the property for $400,000, and he was struggling with his decision.

With only limited time to pay attention to his investment, he has relied on a competent property management company to help him manage the property. The property has a great cash flow. The tenants are all on absolute NNN leases. The mortgage is all paid off. Before income taxes, he's taking home close to $12,000 a month, or $144,000 a year. With a 50 percent tax rate, he nets about $72,000 a year.

He went to see Barry, his CPA, to discuss his options. His CPA told him that he had $2,400,000 in equity, and he had a number of different options. First, he could do nothing and continue collecting rental income and living on that. Second, he could sell it outright, pay taxes and live off the interest on what's left. Third, he could refinance and use the loan proceeds to acquire a second property. Fourth, he could sell using a 1031 tax deferred exchange and reinvest the proceeds into a new property.

Now let's examine the last three options in a little more detail:

He could sell his property and pay capital gains taxes and depreciation recapture. He would net about $1,750,000 in cash. He could deposit this sum in a bank and live off the interest. Assuming a 5 percent return he would get about $88,000 a year, which would be taxed at ordinary income rates of around 30 percent (federal, state and local taxes), leaving him with about $62,000 a year in actual income. If he tapped into the capital, he could raise his pre-tax cash flow to $113,000 a year, assuming he planned on living to age 90. Barry pointed out that the interest income would shrink each year, and that once he sells the property, there would be no more appreciation, nor any way to make any more real money.

He could keep his property, refinance and use the proceeds from the refinance to acquire another property. As an example, he could borrow $1,440,000 and buy another property for $3,600,000. He would obtain some cash flow as well as interest and depreciation shelter for his current income. He could refinance and buy using up to 70 percent leverage but a safer and more conservative level would be at 60 percent leverage. This option would yield him a pretty good cash flow for his 70's and provide more than double the asset value for his heirs or his estate later in life.

He could complete a 1031 tax deferred exchange and trade into another property. His CPA reminded Dr. Morgan that, "in order for an investor's 1031 exchange to be completely tax deferred, the value and equity of the replacement property should be equivalent to or higher than that of the relinquished property. If you take cash out or go down in value in your replacement, then you will pay taxes on that portion of the transaction."

He could take his $2,400,000 and trade into a property conservatively up to three times that amount or $7,200,000. This would grow his asset base, but may not generate the same amount of cash flow in the short term as he is currently experiencing.

The best benefit is that Dr. Morgan would not have to pay Uncle Sam any capital gains taxes. The challenge, in this scenario, will be to find a good property to trade into that throws off as much or more cash flow.

The 1031 exchange offers many investment options for the Doctor:

• another strip center

• Apartments

• Industrial property

• Office property

• NNN investments

• Tenant in common investments

• Land for development

Dr. Morgan's ultimate goal is to maximize his income from his real estate assets in safe investments that won't require much of his time to manage. He knows that when he hits 65, he will be retiring and would like to use the cash flow from his real estate investments to support him and his wife. He also knows that his kids have no interest in real estate and plan to sell everything and use the cash for their own purposes when they inherit his real estate holdings.

Barry stresses how important it is to run scenarios for each of the exit strategies to decide what the best way to proceed is. He suggests working with a knowledgeable real estate broker to help him pencil out his decision, as any one of these options could work.

Finally Barry tells him not to sell anything using a 1031 exchange unless he has lined up his three choices (or 200 percent of the existing value of his current property) to exchange into as the tax hit would be significant and there is no reason to give the government a free $500,000.

As a result of his meeting with his CPA, Dr. Morgan contacts a real estate broker he trusts and together they perform some exit strategy scenarios to focus their search in the right direction.

We encourage you to do the same as you plan for the success of your real estate investments.

Published: August 7, 2007

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Clifford A. Hockley is the President of Bluestone & Hockley Real Estate Services, one of the larger brokerage and property management companies in Portland, Oregon. Mr. Hockley holds an MBA Willamette University and a B.S. in Political Science from Claremont McKenna College. He is a Certified Property Manager and Bluestone & Hockley Real Estate Services is an Accredited Management Organization (AMO) by the Institute of Real Estate Management (IREM). Mr.Hockley serves as member at large on the Portland IREM board. He has twice been named Certified Property Manager of the Year (2001 and 2003) by the Institute of Real Estate Management and is a frequent contributor to industry newsletters.