The 1031 tax exchange had earned it's name rather unimaginatively: it comes from tax code.  This section of tax code mostly revolves around investment real estate.  The government is providing this opportunity for investors as an incentive to keep investing in real estate. 

How does it work?

To explain it simply, one could sell their investment property and not pay taxes on the sale by reinvesting the money back into another investment property.  This would allow an investor to increase their investments. 

Traditionally, these exchanges were allowed so that two owners could exchange their properties tax free.   However, the odds of someone finding a perfect trade are slim.  Therefore, most people execute a delayed exchange.  This means that a third party would hold onto the funds received from selling a property until another property is acquired.  

Important:

• The intermediary must receive the funds directly.  If the seller receives the funds, they will not be eligible for the 1031 exchange. 
  
• Within 45 days of the original sale, a property must be designated as a replacement.  This must be provided to the intermediary in writing. 
• The closing of the replacement property must occur within 180 days of the sale of the previous property. 
• Any cash leftover from this transaction is taxable.  

Please let me know if you have any questions by leaving a comment below.

Why do real estate investors leverage their investment properties?  The most obvious answer is that the more they leverage, the more properties they can purchase.  If purchased correctly, each property should generate positive cash flow.  Not only do the investors get more monthly cash flow with more properties, but they also have more renters paying down more mortgages creating more equity. 

Another reason investors leverage their money is because of the Return on Equity (ROE).  The ROE is calculated by dividing the total annual return by the equity. As you can see in the chart below, your ROE goes down as your equity goes up.  This is why some investors choose to pull their equity out of existing investments and use them to obtain new investments. 

One word of caution: the more you leverage, the more you risk.  Some investors choose to pay their mortgage off and simply receive returns on through cash flow.  

Cash-on-Cash Return is what you would use to compare your investment to other types of investments, like stocks.  To calculate Cash-on-Cash Return, take the Annual Cash flow and divide it by the Down Payment amount. 

                                                     Annual Cash Flow   
                                                       Down Payment

Lets see it with an example from Camden Towns.

                                                            Investment Anaylisis from HarrisonburgInvestmentProperties.com

This is a continuation of a serious entitled: The Top 10 Terms of Commercial/Investment Real Estate. 

Most buy and hold real estate investors agree that cash flow is the ultimate goal.  To calculate cash flow, you take the NOI and subtract it by the Debt Service.

NOI - Debt Service = Annual Cash Flow

See how the cash flow is calculated for Pheasant Run in Harrisonburg.  Click here for available properties. 

This is a continuation of a serious entitled: The Top 10 Terms of Commercial/Investment Real Estate. 


Cash Flow Calculations Source:
http://www.harrisonburginvestmentproperties.com/pheasant-run/

Debt service is simply the mortgage payment associated with a property.  This can be annualized by multiplying one payment by 12. 

If you are considering purchasing a property that has a NOI of $60,000.  To better understand what your cash flow will look at, you will want to subtract your debt service from the NOI. 


Example Property 1

                                             NOI:          $60,000

Monthly Mortgage Payment:           ($896
                                                                  x    12)
Debt Service                            -         $10,752              

Cash Flow                                           $49,248          


This is a continuation of a serious entitled: The Top 10 Terms of Commercial/Investment Real Estate. 

The net operating income is the income minus the expenses excluding the mortgage.  The NOI is used to help determine the profitability and value of a property.  So, the NOI is effectively what the property would be making a person who buys in cash. Here's an example.

                                               Annual Income: $100,000
-                     Annual Operating Expenses:    $45,000
__________________________________________________
                      Net Operating Income (NOI):    $55,000


The NOI is important if you are thinking about purchasing a property.  It will not only give you a sense of what you will be earning but it will also help the bank determine if you can afford the mortgage payments.  If you own the property, it's a helpful tool to help determine the value of your asset.  Furthermore, you can look to increase the value by increasing the NOI. 

This is a continuation of a serious entitled: The Top 10 Terms of Commercial/Investment Real Estate. 

Operating Expenses are what it costs to run a business.  Some examples of operating expenses include: taxes, insurance, utilities, management fees, landscaping, maintenance, repairs, and advertising. 

The following is what buying a Campus View Condo may look like.  The expense sheet is from HarrisonburgInvestments.com

This is a continuation of a serious entitled: The Top 10 Terms of Commercial/Investment Real Estate. 

 Effective Gross income is also known as EGI.  This number is one of the first things you will want to look at when determining a property's income potential.   This will be a key figure in determining the Net Operating Income.

Keep in mind that you can add other income sources such as parking, vending machines, laundry, etc...

The following is an example of calculating EGI:

Gross Income – Vacancy Costs (vacancy rate (%) x income = $ amount) – Credit Loss (i.e. collections, evictions, etc) = Effective Gross Income (EGI)

For example, using the same property information above:

Gross Income: $120,000

(minus)Vacancy Rate (20%): $24,000

(minus) Credit Loss (2%): $2400

(plus) Additional Miscellaneous Income (Laundry, Parking, etc.): $3500

=Effective Gross Income (EGI): $97,100


This is a continuation of a serious entitled: The Top 10 Terms of Commercial/Investment Real Estate. 

Example Source: Biggerpockets.com

Vacancy rate is the percentage of vacant units in comparison to all the units in the property. 

                                                         Vacancies    
                                                         Total Units

An example would be if a hundred unit property had 5 vacancies, the property would have a 5% vacancy rate. 

As mentioned in the Vacancy blog, one could purchase a property at a discount, due to a high vacancy rate,  solve the reason for the vacancy, fill the vacant units, and then have a more valuable property. 

This is a continuation of a serious entitled: The Top 10 Terms of Commercial/Investment Real Estate. 

Gross income is the total amount of income you can get in a property.  This is important to understand because this number isn't necessarily guaranteed.  For example, if a property has 4 units that rent for $500 a month, the gross income would be $2,000 a month. However, this property may only be partially rented.  

Having a property only partially rented could be a bonus if the purchase price reflects the occupancy status.  In other words, if you buy the property and make do what it takes to make it fully rented, you can increase the value of the property quickly.  

In addition to rent, other items such as coin operated laundry, storage fees, late fees, vending machines, etc, can be factored into gross income. 

Top Ten Terms for Commercial and Investment Real Estate