Available Capital Is King
When Buying Real Estate

Question: Several months ago, I came across a classified ad for a strip mall for $15 million. I am interested in buying an established strip mall. How does one normally finance this sort of venture? What out-of-pocket expenditures are required up front? What sort of experience in property management do financiers look for? My intent is to own the strip mall and not manage the property, as there will already be a property-management system in place.

William: Retail properties are usually financed by commercial banks and conduit lenders using the property as collateral for the loan. The lender could also look for the borrower to provide personal guarantees for repayment of the loan.

As for out-of-pocket expenditures required up front, Bernard Haddigan, national director of Marcus & Millichap Real Estate Investment Brokerage Co.’s national retail group, says typical expenditures would include a negotiable earnest-money deposit. At the point of closing, expenditures would include the down payment -- typically 25% to 40% of the purchase price, plus loan fees, title insurance, closing fees, attorney's fees, and inspection fees.

As for experience lenders look for, the main criterion is available capital, including the necessary down payment and reserves to close the acquisition. Mr. Haddigan adds that in the underwriting process, lenders typically will want to see the resumes (and have the right to approve) of the proposed property manager and leasing agent to make sure an appropriate strategy is in place to protect the value of the asset. Good luck.

Question: Can a property acquired via a 1031 exchange be sold as a primary residence and be exempt from capital-gains taxes? Suppose the owner exchanged one rental-investment property for another in a different state. After one or two years of renting out the new property, the owner moved in and made it his primary residence. After two years of living in this primary residence, the owner is hoping to sell it and not have to pay capital-gains taxes on the exchanged property (the original rental-investment property which was tax-deferred under 1031), or the primary residence.

Zoran: The answer is yes, but not in Georgia and with consequence in California and Oregon. In a 1031 exchange, owners defer capital-gains taxes on the sale of their property by exchanging it for "like-kind" property. In most cases, a third-party intermediary prepares the exchange agreement and handles the money. The property the seller wants to buy has to be identified within 45 calendar days of his sale and purchased within 180 days.

Louis S. Weller, a principal at Deloitte & Touche LLP’s national real-estate tax-services group in San Francisco, says the transaction you describe can be done. "There is no fixed minimum time after acquiring a rental property in a like-kind exchange before it can be converted by the owner to a personal residence," he says. "The key will be to wait long enough so the IRS can’t successfully claim that the owner always intended to use the property as a residence." Doing such a thing, he adds, would violate the Internal Revenue Service’s Section 1031 requirement that, at the time of the acquisition, the owner intended to hold the property for trade or business or investment purposes, not for personal use. The final sale of the property once it is a primary residence should qualify for exclusion under Internal Revenue Code Section 121.

However, things get more complicated when it involves an exchange with relinquished and replacement properties in different states, Mr. Weller points out. In Georgia, deferral of taxes on gains from a property sale is possible in a 1031 exchange only when the replacement property is located in Georgia. In California and Oregon, if in-state property is exchanged for out-of-state replacement property, a future sale of the replacement property can trigger an obligation to pay the state tax deferred on the original exchange.

-- Mr. Smith is a staff reporter for The Wall Street Journal. His "Building Value Q & A" column appears each month exclusively on RealEstateJournal. Click here to e-mail him a question about investing in real estate.

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