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We often hear about how the lines of credit have dried up in our current market. Banks are hesitant to lend even to the most credit-worthy individuals, and as for those of us who may not be as qualified…well let’s just say our inquiries are not being fielded at the moment. This creates a somewhat paradoxical problem; because we are also hearing that with prices at such low levels, now is the time to buy. So the question is: How can the enterprising amongst us take advantage of real estates low prices without the support of the traditional banking structure? The answer could lie in something which most people look upon with a sense of abject suspicion, the Promissory Note.

To demonstrate how a Promissory Note can be of invaluable support, let’s look at a quick example:

Suppose Mr. X wanted to sell his current land, valued at $5 million, through a tax deferred 1031, and use those proceeds to purchase an office building alternatively valued at $5 million. A complication is encountered when Mr. Y, the one person willing to buy Mr. X’s land, has only $2.5 million available. In credits better days there was a simple solution, Mr. Y would take out a $2.5 million loan from the bank and thus be able to pay Mr. X the $5 million in cash. But these are not credits better days, and there is little chance of Mr. Y getting a loan. Especially since this transaction involves land, which already populates the balance sheets of many banks, and the opportunity to own more is not welcome. The solution is Mr. Y contracts to give Mr. X $2.5 million in cash and a $2.5 million note, thus covering the $5 million total. Essentially, with the lack of banking support, Mr. X acts as a surrogate bank and enables the deal to go through.

Note: Because this is a 1031 exchange neither cash nor note would go to Mr. X directly, but to his Qualified Intermediary (QI).

As we can see, where a deal normally wouldn’t be completed, the assistance of a note pushed it to fruition. However, the question that invariably arises is “what does Mr. X do with that piece of paper?” This is a problem because though the note may say $2.5 million no one in the market will buy it for its face value. Traditionally, if a note is sold it is always at a discount, requiring Mr. X to take a “haircut” on the value of the note. However, as you will see, the discount may be worth it.

In terms of a 1031 exchange, there are three options for dealing with a note:

  • If Mr. X has the available cash he can simply buy it back from his QI, who is required to hold it by law pursuant to the exchange rules. This is the best case scenario in which Mr. X takes no loss on the note and still has the necessary capital to make his exchange possible. The problem of course is that it is rare someone has the spare cash to make this transaction, especially in a commercial transaction.
  • Mr. X or his broker can sell the note to a third party. This would provide an instant inflow of cash but it would inalterably be less than the face value. For example, a buyer may only be willing to pay $2.1 million for the note which is valued at $2.5 million.
  • Someone can be found who will accept the note in conjunction with cash in the property exchange. Here you simply side step the issue of having to sell the note for cash and instead directly included it in the deal. The problem again is that this will most likely require you to pay more cash to compensate for the note. So where normally a property would cost Mr. X $5 million, with a $2.5 million note that price may go up to $5.5 million.

Essentially it all comes back to converting the note for cash which inherently is a shifting of risk. So the question begs to be answered, “why are notes effective?” The answer is they can provide brokers an opportunity to do what they do best, put people together, and create a win-win situation for all parties. If properly executed, you can have a seller with a successful 1031, a broker who has sold both the “old” and “new” properties; and a satisfied buyer of a note who achieves opportunistic, superior returns in this tumultuous market.

So in the example above, Mr. X could take the cash he received from Mr. Y, combine that with the revenue from the sale of the note and leverage that money with a little extra cash of his own to buy the office building he desired. Essentially trading a piece of land which earns no rent for a building which can earn substantial returns each month. Or if he didn’t want to invest extra cash, Mr. X could simply trade down to a less expensive property, say a $4 million dollar Walgreens, not add extra cash and enjoy the constant stream of revenue the Walgreens would provide. The point is that in a market which many are finding hard to transact business in, there are ways as simple as a note to make profitable deals happen.

 
Featured Exchange Counsel
  James Brennan, Esq.,LL.M.
Managing Director/Corporate Counsel
11150 Sunset Hills Road
Suite 300
Reston, VA 20190
Direct 703.801.4178
Fax 703.663.9889
jbrennan@1031esgroup.com
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