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How Creativity Can Produce Huge Tax-Free Profits

by Ernest Tew   

After forty years in this business, I still enjoy solving problems. What I enjoy most is helping others succeed when faced with the challenge of acquiring a problem property and making it profitable. One of the best examples we have seen was a mobile home park in Jacksonville, Florida.

Due to inadequate management and poor maintenance, 52% of the lots were vacant. With a cash flow deficit of nearly $11,000 a month, the owners were desperate to sell. Unfortunately, a sale would create an even bigger problem.

The group had held the property for more than twenty years, taking the maximum depreciation deductions allowed. Their tax basis was not much more than the original cost of the land. A few years earlier, they refinanced the park, and the current mortgage balance was almost $900,000.

Even giving the property away or losing it in foreclosure would have resulted in a major tax problem. When selling or otherwise disposing of property, any debt relief that exceeds the owner's tax basis is taxed as if it were received in cash.

Mike had found the property and recognized the potential. But he didn't have the money or experience necessary to take on such a large project. He contacted me for help in putting a group together to acquire the property. Before getting involved or recommending it to my investors, I had to be convinced it would be a safe and profitable investment.

We solved the owners' problems

After a lot of thought and conversation, we were able to solve many of the owners' problems--while reducing our risks and cash requirements--by entering into an eight-year lease with an option to buy. To limit our liability, we formed a limited partnership to lease the park, manage the business, and deal with the public.

Mike devoted full time to turning the park around. For services rendered, he would receive an agreed percent of any net cash income and a share of the gain when the property was sold. Six investors contributed a total of $300,000 in cash.

However, we invested only $105,000 in the limited partnership. It was used to pay the first year's lease payment, closing costs, buy a few pieces of equipment, and leave a little start-up capital.

The other $195,000 was put into a business trust. This separate entity was designed to provide maximum protection for the money we invested and the equity we expected to create. The trust used $50,000 of the funds to pay for the option. From time to time, the trust made loans to the limited partnership to pay for park improvements and operating losses.

Enormous benefits for everyone

By entering into a net lease with an option to buy, the owners were able to solve their management problems and would no longer have to contribute nearly $11,000 a month to cover operating losses. They received $75,000 in cash, of which only $25,000 was taxable at that time.

The $50,000 in option money didn't have to be reported on their tax return until the option expired in eight years--or when the option was exercised, at which time it became a part of the selling price.

Since the park was not sold at that time, the owners avoided a major tax problem. They now had up to eight years to find ways to offset the capital gains taxes that would be due when the park is sold.

The investors had a safe, management-free asset that would soon earn a substantial profit. Along the way, they contributed another $31,000 to cover promotions and additional fix-up work.

One million in net profit

Two and a half years after taking on the project, and before completing the turn-around work, we sold the property for $2.7 million cash. After receiving credit for the $50,000 paid for the option, the trust had the right to buy the park for $1,350,000. Fortunately, it wasn't necessary for us to come up with that kind of money.

We purchased the park and sold it at the same time, paying for it out of the sale proceeds. Suddenly, the net worth of our trust had increased from $226,000 to about $1,350,000. After prorating taxes and rents and paying a few selling costs, the net profit was still above $1 million.

I think it is crucial to hold one's "real wealth" in a way that it will be safe from those who would take it from us. Although the return on our investment was quite high, our equity in the trust was always safe from lawsuits and most other risks.

Of course, the investors were pleased to participate in a project that offered such a high return with so little risk. However, the real bonus was in the fact that most of them will never be required to pay income taxes on their share of profits.

About the Author:

Ernest Tew majored in real estate at the University of Florida and has been involved full-time in real estate investments since 1960. He has been actively involved in the acquisition, development, management, and marketing of more than $200 million worth of real estate.

He was president of the Gainesville, Florida, Board of Realtors in 1965, the youngest Realtor to hold the presidency at that time. In 1983, he was one of only seven in the country to receive the Academy Certified Exchanger designation from The Academy Network.

In 1989, he received the Golden Eagle Award, the highest award given by the Academy, for the creative way he structured the purchase of the 20 story Founders Tower office building in Oklahoma City, one of the best known landmarks in the state.

 
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