|
FEATURE ARTICLE, MAY 2005
RISING INTEREST IN 1031 EXCHANGES
Craig Taylor
In the past several years, the 1031 tax-deferred exchange has become increasingly popular with commercial real estate investors who desire to shuffle portfolios and defer capital gains taxes. More overall funds are chasing commercial real estate than ever before due to low interest rates and an exodus from the more volatile stock market, and property owners now are receiving offers with a very low basis on their properties. Rather than paying the taxes on these gains, owners are choosing to trade into other like-kind real estate via the 1031 exchange. While a rise in interest rates likely would have an impact on the volume of exchanges, industry professionals see no obvious end in sight.
In a 1031 exchange, a property owner sells his or her property and holds all proceeds with an exchange accommodator in a separate account. The owner then has 45 calendar days after the original closing date to identify properties he potentially will purchase through the accommodator; typically, one can identify no more than three properties. If more than three properties are identified, the total estimated value of all the properties can be no more than twice the value of the sold property, and, depending on locale, there may be more stringent rules in the tax code. Six months from the sale’s closing date, the replacement property must be purchased. In the event that the total price of the replacement property or properties is not greater than the original property’s sale price, then the owner is responsible for the taxes on the portion less than the original price. A 1031 investor must replace more equity and more debt than the original price to defer all of his gain.
1031 exchanges allow tax deferment, which is an obvious advantage, but a lesser known advantage allows owners to diversify their portfolios. For example, an owner can diversify from one $3 million property into two or three properties of $2 million each. An owner who may have a small loan on the sold property then can purchase other properties and place a 75 percent loan on them without adding any additional cash. Owners also may sell an older property that has appreciated and can trade for a newer property, or they can trade a property that’s more management-intensive to one that requires little or no management. For example, we are receiving significant interest from buyers who have sold apartments and now desire retail.
Interest rates help fuel 1031 activity but are not the sole factor. I believe interest rates are certainly a big factor in the reduction of capitalization rates and the resulting increase in prices.
Reverse 1031 exchanges also are a popular investment option for property owners. A reverse exchange allows an investor to purchase a property and then, within a certain timeframe from the initial closing of the original acquisition, he can identify another development currently under ownership for disposition. In the event that the second sale does not occur, the investor will be required to pay capital gains taxes on the realized gain.
A version of this exchange, a reverse build-to-suit exchange, which also is referred to as a construction or improvement exchange, allows you to build, construct or make capital improvements to a property before acquiring it as your replacement property in a 1031 exchange transaction. The exchange proceeds from your relinquished property can be used to fund the construction or build-out.
There is no one property type that works better than others in completing a 1031 exchange, but most properties are well suited. Type of ownership — whether there is debt on the development or it is owned free and clear — also is irrelevant. Traditionally, properties in larger markets have gained more attention from buyers, thus resulting in a more logical fit for 1031s. 1031 buyers, especially those from larger markets or from the West Coast where cap rates are lower on average and where demand is greatest, most recently have migrated to the East Coast and even to smaller markets. In several states, if you sell property in one and purchase a 1031 exchange property in another, you will be responsible for paying a state tax in the location where you sold property.
Finally, those investors who pay attention to the markets, who have a low basis in the property they are selling and diversify from one property into another will benefit the most from a 1031 exchange.
Craig Taylor is first vice president – retail investment sales for CB Richard Ellis’ Atlanta office.
©2005 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
from France Publications, Inc. For information on reprints
of this article contact Barbara
Sherer at (630) 554-6054.
|
