By Dorothy Hinchcliff
The strong real estate market in many areas of the country may be one reason that interest seems to be growing in 1031 exchanges, a technique used to defer capital gains taxes on the sale of appreciated investment or business property.
Also contributing to the trend, observers say, are landlords in their fifties and sixties who want to defer capital gains and stay invested in real estate, but reduce their activity. Some are scaling down from larger buildings to smaller ones, while others are choosing sponsored “Tenancy In Common” arrangements, which allow them to be one of many passive investors in a commercial property. (See sidebar.)
Others say it’s just an increased awareness that Section 1031 of the Internal Revenue Code allows such deferrals. But to get the benefit, investors must comply with a specific set of rules. Among the most important requirements are that after the sale, a like-kind replacement property must be identified within 45 days (up to three possibilities can be identified) and closed upon within 180 days. A qualified intermediary must hold the proceeds from the sale until the other property is purchased.
Although advisors and others report rising interest in 1031 exchanges involving real estate, no one has an accurate number on exactly how many of them are being done. The IRS, which requires Form 8824 to be filed for like-kind exchanges, does not have recent numbers on how many such forms were filed. Its latest figures show 108,537 forms filed in 2000 by individual taxpayers, and 45,078 filed in 1997 by corporations.
And these numbers include more than real estate transactions. The IRS permits like-kind exchanges of many types of business property-airplanes, livestock, computer equipment and even copyrights, for example, may qualify under Section 1031. But exchanges of stocks, bonds, notes, partnership interests and other securities don’t qualify.
Tim Egan, executive director of the Federation of Exchange Accommodators (FEA), a business organization representing qualified intermediaries, says that although the number of 1031 exchanges is unknown, the FEA believes they are rising because member companies are reporting increased activity. The FEA has almost 300 members and represents 85% of known, full-time qualified intermediaries in the United States.
“We’ve gotten general input that leads us to the strong and accurate conclusion that most 1031 transactions are done basically by individual taxpayers, a husband and wife who have a modest duplex and want to trade into something of similar value,” Egan says.
Advisor John LeBlanc, co-founder of Back Bay Financial Group in Boston, has had many client couples consider 1031 exchanges, and he believes the strong real estate market in the area has helped fuel their interest. “In the Back Bay and South End of Boston near my office, I’ve had clients who bought brownstones for $100,000 twenty years ago and now they’re going for $1.2 million to $1.5 million. It’s like Park Slope in Brooklyn. The area got better and more desirable,” he says.
George Middleton, an investment advisor with Limoges Investment Management in Vancouver, Wash., helped a client do a 1031 exchange with an office building. “He got an offer on his building in Seattle, and it was kind of an offer he couldn’t refuse,” he says. The property was close to King County International Airport/Boeing Field and an interchange off Interstate 5, which made the property extremely valuable, he explains.
“He sold the building for about $850,000, and his basis was down to about $160,000, since he’d depreciated it. So he had an almost $700,000 gain that he would have had to pay taxes on,” Middleton recalls. Using a 1031 exchange, the client replaced the Seattle building with one in Sacramento and one in Vancouver, he says.
It’s not just clients making using of 1031 exchanges-advisors are using them, too. In fact, Middleton says he did one seven years ago with a partner in which they exchanged a condominium in Bend, Ore., for raw land there. “The original reason I bought it was to go skiing, but I wasn’t getting the use out of it I wanted,” he says. “Since the condo was in a resort area, there were a lot of fees, we were paying monthly maintenance and so forth, and we’d already benefited from the depreciation of it. The cash flow was at best even and certain months negative.”
Although the condo sale produced only a 5% gain, the raw land has doubled in value and has a lot fewer expenses, he notes.
Advisor Richard Hammel, founder of Hammel Financial Advisory Group in Nashville, Tenn., also has helped clients do 1031 exchanges and did one for himself. In his exchange, Hammel took proceeds from the sale of an auto parts store, which he and his brother owned as tenants in common, and invested his share in an office condominium.
“There’s always an opportunity for this because people have a lot of value in real estate. We’ve done it with clients where they had farmland with a low basis that they inherited many years ago and they exchanged it for rental condominiums,” he says.
The FEA’s Egan says he thinks the aging of the population also is generating more interest in 1031 exchanges. “We’re finding a lot of people-and baby boomers are now getting into this age category-want to get out of active and aggressive real estate investments and do something more passive so they don’t have to worry about collecting rent.”
Raw land is one option, he says, as well as sponsored tenancy in common arrangements.
LeBlanc agrees a lot of aging landlords are looking for alternatives. Although 1031 exchanges may provide big tax advantages, some clients forego doing one because they no longer want to own commercial property. Others do an exchange, but might sell a four-family and buy a two-family. Still others might sell a larger rental property and buy a single-family summer rental, with the idea of converting it in the future to a second home, LeBlanc says.
John Kimball, principal partner of The Exchange Authority, a qualified intermediary based in Boston, believes the increase in 1031 exchanges has resulted because people have become more aware of them. “I think the public is certainly becoming more aware of the benefits of doing an exchange, and their advisors are pushing the transactions more today,” he comments.
Mary B. Foster, general counsel for Section 1031 Services Inc., a qualified intermediary in Bellevue, Wash., notes the U.S. Department of the Treasury adopted regulations in 1991 that clarify how 1031 exchanges should be done and made them easier to do. “I know from talking with other intermediaries that the volume seems to be increasing as more people learn of the benefits,” she says. “This is true even with the down economic times. The lower capital gains rate will have a minor impact.”
That’s because the tax rate on unrecaptured depreciation remains at 25%, so there are still great benefits for improved real estate exchanges, adds Foster, a member of the American Bar Association Tax Section Committee that made recommendations to the IRS on how to increase taxpayer compliance with the 1031 rules.
In spite of their advantages, 1031 exchanges can be troublesome. Foster says the requirement that replacement property must be identified within 45 days of the sale is probably the biggest reason the exchanges fail. “It sends a lot of people scurrying and pushes them into bad deals,” she says. But even the IRS can’t change that-it’s a statutory requirement that Congress would have to change, she notes.
Advisor Gary N. Greenbaum, president of Greenbaum and Orecchio Inc. in Old Tappan, N.J., finds the exchanges don’t work for most of his clients, although he’s been involved in at least a dozen in the last three years. “The good news is not that big-it’s only the investment earnings on the tax payable on the deferred capital gains,” he says.
That has to be compared with the price you must pay to earn that money, he continues. The costs can add up from lawyers, intermediaries and advisors. “And this is the biggest one: The rush to comply with the 45 days and the 180 days to close. They are so burdensome and onerous that they make 1031 exchanges questionable at best and burdensome in reality because what it forces you to do is accept properties that are not always the best choices.”
A New Choice For Real Estate Investors
Sponsored Tenancy In Common (TIC) arrangements might appeal to clients who want to do 1031 exchanges but don’t want to actively manage real estate any longer.
The Internal Revenue Service has long maintained that like-kind exchanges of interests in partnerships, REITs or other business entities-which often are set up to hold real estate and are more passive investments-don’t qualify for capital gains tax deferral under Section 1031.
However, real estate owned by tenants in common does qualify, and now some companies have packaged ownership of multi-million dollar, triple-net-leased commercial properties into tenant-in-common units of as little as $50,000. Triple-net-leased properties often are rented to national companies with good credit that are responsible for paying all expenses, including property taxes, maintenance, utilities and so on. As a result, investors can get a steady stream of rental income without having to actively manage the property.
Last year the IRS issued Revenue Procedure 2002-22, which specifies the conditions that must be met for it to issue a private-letter ruling saying a TIC is an undivided fractional interest in a rental property and not an interest in a business entity, such as a limited partnership. Many observers say they expect the announcement to accelerate the trend of using TICs as replacement property in 1031 exchanges.
For the IRS to consider issuing a ruling, 15 conditions must be met. Among them:
* Each co-owner must hold title to the property.
* The number of co-owners must be no more than 35 people.
* The co-owners can’t operate as a partnership or business entity or file a partnership or corporate tax return.
* Co-owners retain the right to approve the hiring of any manager, the sale or disposition of the property and any leases.
* In general, each co-owner must have the rights to transfer his undivided interest without the agreement or approval of any person.
Mary B. Foster, general counsel for Section 1031 Services Inc., a qualified intermediary in Bellevue, Wash., says the IRS hasn’t released any rulings yet on specific TICs, although some sponsors have gotten rulings that haven’t been published yet.
TICs may make sense for some buyers, particularly if it’s a good property, she says. But investors need to look at upfront fees, which can be significant-as much as 15% to 25% of the initial investment, she says. Also, returns quoted often incorporate the tax deferral an investor would get by doing a 1031 exchange, Foster adds.