The Gains of Exchange
by Eric Scaff
Whatever your motivation to sell (the active management, the highly regulated rental market, the tenants), we find it generally balanced by a similar reluctance to sell (potential large tax liability, where to reinvest the proceeds, how to achieve matching returns to your current long-term investment). It is important to understand all of the factors associated with the sale and some strategies that may be available to you in the marketplace.
This article is about the 1031 Exchange process and function, however, each individual investor should consult with a good CPA or tax advisor who is versed in the 1031 rules and guidelines about their specific situation (e.g. application of other tax loss carryforwards, cash needs, etc.).
The basic considerations are to either pay the tax liability from the sale or to defer those taxes through a 1031 Exchange. The tax liability from the generated sale can be a federal capital tax, a state capital gains tax, and the federal depreciation recapture. The rates vary per individual and entity, however, as a rule of thumb in California, for example, there would be federal capital gain in the 15%-20% range, state capital gain up to 13%, and a 25% recapture of any depreciation taken during the hold period. When these are all taken together, we generally see a tax liability number in the 30%-40% range.
For investors looking to defer any capital gains and depreciation recapture liability, one option they may engage in is a 1031 exchange as allowed from an I.R.C 1031. The code provides an exception and allows investors to postpone paying tax on the gain if they reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Keep in mind: gains deferred in an exchange are tax-deferred but not tax-free.
The Internal Revenue Code provides several requirements to effect the desired deferral of the capital gains and other taxes. The property being sold is generally referred to in the industry as the “relinquished property.” To properly effect the exchange, the investor must trade the relinquished property for “like-kind” property of equal or greater value to be held for investment purposes. “Like-kind” is a broad term and leaves lots of options for the replacement property. Another way of thinking about “like-kind” is real property exchanged for other real property, being held for investment purposes. It is not just a house for a house, or an apartment for an apartment. While that could be a satisfactory solution, it could also be a house for an office building or a retail asset for a parcel of land, for example.
At the time of sale of the relinquished property, all sale proceeds need to be distributed to and held by a “disinterested 3rd party,” more commonly referred to as a Qualified Intermediary (QI) or an Accommodator. Prior to the sale, the investor will set up an exchange agreement with the QI. Should any proceeds from sale be distributed to the investor, they will be disqualified from the exchange and be required to pay the tax liability. There are numerous QIs in the marketplace, several firms that are subsidiaries or related to the major title companies, and many independent firms that could be associated with CPAs, tax attorneys or banks. Two major considerations for selecting a QI include overall fees charged and security of exchange funds.
When the closing has occurred and the funds have been distributed to the QI, the investor must identify formally and in writing to the QI the replacement property to be purchased. There is a 45-day time limit from the date of closing of the relinquished property until the investor must identify to the QI. The investor now has an additional 135 days to close on the replacement property (180 days total from the closing of the relinquished property). There are three primary rules that can be used for identification to the QI. These are referred to as “the three property rule,” “the 200% rule” and “the 95% rule.” Most investors use the three property rule where the investor can list three potential replacement properties and the investor can close on one, two or all three of the properties.
In summary, to effect the exchange, the investor signs an exchange agreement with a QI and distributes the sales process to the QI at closing. The investor finds and then identifies replacement property selections to the QI within the 45 days. The investor then closes on the replacement property within 180 days of closing the relinquished property.
Sounds easy—so, what are the challenges? Many investors in this process have related a number of challenges that make it a little more difficult than they anticipated. Primarily, investors are concerned with the 45-day timeframe to identify property, their ability to find and identify appropriate and qualifying, quality replacement property, and what to do if the ideal replacement property is a little lower in value than the relinquished property. To address the first issue of the timeframe, investors can buy themselves some additional time by starting the search for the replacement property as soon as they know they will be selling their relinquished property. This can give investors more time to find the right replacement property. The 45-day clock starts ticking the day the relinquished property closes escrow, so starting before gives you more time. Finding a property that meets the investor’s needs is a bit more difficult in a strong market as there is more competition on the buy side. When the right property is found, it makes sense to be aggressive about getting it into contract. Typically, both buyers and sellers have sensitivity to the exchange process and are generally willing to make some accommodation to support the process. It is also important to remember that if you can be in contract for the replacement property prior to day 45 (Identification Day), you greatly reduce the likelihood of a blown exchange.
In the event that the desired replacement property is of some lesser value than the relinquished property, the difference is considered “boot.” The boot amount would be taxable. To avoid boot, most investors either buy more expensive property and take on a little more debt or add some additional cash. Depending on each investor’s specific situation, having a little bit of boot may be considered a positive as they can take out an amount of cash, pay the tax on that portion, and hold the after tax amount for other uses.
For the exchange investor looking for a more passive investment, there are a few options. Most are aware of the triple-net lease properties (NNN) that are generally single tenant assets with long-term leases with tenants of varying credit
quality. These types of investments have very little or no landlord responsibilities and generate cash flow through the lease payments.
There is also the Delaware Statutory Trust (DST). This is a passive investment available to accredited investors to purchase fractional interests in institutional quality property. The investment sponsors are professional real estate investment firms that find, acquire and package single-asset or multiple-asset programs for investors. The programs generally come with a conservative level of non-recourse debt and are projected to make monthly cash distributions to investors based on their pro-rata interest in the program. The DST has been approved for 1031 exchanges under IRS Revenue Ruling 2004-86.
While diversification doesn’t guarantee results, investors can potentially use the DST to help diversify, investing across multiple programs or to offset boot. For example, if an ideal replacement property is of less value than the relinquished property, some investors use the DST for the small remaining amount to satisfy the minimum purchase amount. It should be known that the DST is an illiquid investment as there is no real secondary market for these interests. The investor is trading control and liquidity for passive management and the value that the investments sponsors bring to the equation.
In addition to the DST, many of the same investment sponsors will create custom solutions for the larger exchanges, say, greater than $7 million. In these custom solutions, there are a number of strategies that can be used to achieve various outcomes. These custom solutions can potentially provide the investor with a little more, say, in the property decisions, but still would be considered passive and carry a host of other benefits and risks, such as the potential to experience entire principal loss, declining market values, and tenant vacancies.
As with all investing, it is important to consult with necessary professional advisors like CPAs and property or tax attorneys. The 1031 exchange can be an important and useful tool to enhance certain investor goals, but should be contemplated in the overall picture of each investor’s specific situation.