A credit tenant loan (CTL) is a strategy that focuses on obtaining the maximum amount of cash out of a real estate transaction. This strategy relies on a 1031 exchange, but the exchange is only the vehicle for providing cash from the sale. Some property owners want to sell their property, cash out, and pay the taxes they owe rather than completing a 1031 exchange. Most owners also want to reduce their taxes on the capital gains from the sale. With a credit tenant loan, you can do both.
How You Can Do Both
For the 1031 exchange strategy to be effective, the relinquished property should have limited or no debt. The replacement property is purchased with cash via a 1031 exchange. Shortly after the replacement property purchase has closed, the property is refinanced and a CTL is used that is specific to the type of tenant and length of the lease. With a CTL, collateral for the loan is not the property, it's the credit strength of the tenant. The better the tenant’s credit, the better the terms of the loan. (For more, see: 1031 Exchanges: 10 Things to Know.)
The credit tenant is usually a national company with an institutional credit rating of BBB (or higher) and the primary term of the lease should be close to 20 years or more. Replacement properties with institutional-quality tenants and leases of sufficient length are available and can make this strategy viable. With a lease that is close to 20 years, CTLs can exceed 80% loan to value (LTV). Some of their LTV valuations approach 90%.
The loan is fully amortizing over the remaining term of the lease. A shorter-term lease will reduce the LTV on the loan, because the length of the loan is the same as the remaining original term on the lease. If the loan or lease term is too short, it can adversely affect the viability of this strategy. The loan has a one-to-one debt coverage ratio, meaning the loan payment is equal to the rents received from the tenant. In a loan, as leverage increases, cash flow decreases.
Since the investment produces no cash flow, the loan proceeds are maximized. And because this is a loan, it's a non-taxable event. The loan is based on the tenant’s credit strength so the mortgage risk to the investor is minimal.
Keep in mind that a CTL loan can create phantom income, which is taxable. The phantom income is equal to the reduction in principal balance during the tax year and is offset by the fact that there is no cash flow from the property that would require payments for tax liability.
It's recommended that investors evaluate the positives and negatives relative to their particular needs. By using a 1031 exchange in combination with a credit tenant loan strategy, one can achieve a higher level of cash from the sale of relinquished property than by directly paying taxes. Another benefit of this strategy is that the loan on the property will be paid down according to the mortgage, which allows gains from the property to be realized again. (For more, see: Avoid Capital Gains Tax on Your Home Sale.)
Disclosure: IREXA® Financial Services / Wealth Strategies collaborates with CPAs, attorneys, and other tax planning professionals to assist clients with tax mitigation strategies. IREXA® and Great Point Capital, LLC are not tax professionals or attorneys. IREXA® only provides client tax mitigation strategies through, and with the approval of, the client’s professional counsel. Securities offered through Great Point Capital, LLC, Member FINRA/SIPC, 200 W Jackson Blvd #1000, Chicago, IL 60606, telephone (312) 356-4872. IREXA® Financial Services / Wealth Strategies is not affiliated with Great Point Capital, LLC.