Last year, Inland Group Inc. traded up and the Internal Revenue Service helped. The Oak Brook, Ill.-based company exchanged the Shorecrest Shopping Center, a grocery-anchored property in Racine, Wis., for an interest in a regional big box center called Deer Trace, located in Kohler, Wis.

To pay for the $13.5 million center, Inland used the entire $6.2 million garnered from the sale of Shorecrest (including the value of deferred capital gains taxes), plus an equity contribution of $7.3 million. In return, the company acquired a larger property that's also a better profit spinner, thanks to high-profile retail tenants that include Home Depot, T.J. Maxx, Michaels Arts & Crafts and Famous Footwear.

What made this deal — and thousands more — possible is the 1031 exchange, a method of swapping the value of one property to buy into another that, unlike an outright sale, defers capital gains taxes. For retail property owners, the 1031 exchange is one of the few remaining real estate tax shelters.

1031 101

Not so long ago, 1031 exchanges were an essential tool constantly relied upon. Indeed, REITs made use of the method to build their portfolios. “That's how we bought the Edward J. DeBartolo Corp. in 1996,” says Stephen E. Sterrett, chief financial officer of Simon Property Group in Indianapolis. “It is also how we bought New England Development, a piece of Retail Property Trust, and many other malls.”

Today, retail owners like Inland Group routinely use 1031 exchanges to swap older properties for newer, trendier ones that will throw off better returns; the company acquired 85 properties valued at just under $1 billion during 2002 and used 1031 exchanges to fund a dozen of those acquisitions.

Exchanges not only funnel capital into acquisitions, they form exit strategies for properties that have peaked in value. “You can exchange into a larger property with more cash flow,” explains Inland Vice-Chairman Joe Cosenza.

While no one tracks the 1031 exchange market systematically, however, most swaps involve small multifamily rental properties with one to four apartments, says Javier VandeSteeg, president of Asset Preservation Inc. of Granite Bay, Calif.

Deloitte & Touche estimates 1031 exchanges account for about $30 billion of business annually. Only about 10 percent of that total involves retail real estate, VandeSteeg explains. And of those, half are conducted by shopping center firms swapping one property for another.

So why not more? It's a question of timing, experts say. In a 1031 exchange, owners defer the capital gains tax they typically pay in a property sale, by essentially paying for the new property with the title of the relinquished property. To insure that the exchange will defer taxes, the equity held by an investor in the new property must equal or exceed the equity held in the previously owned property.

Most 1031 exchanges, including delayed and reverse transactions, revolve around two absolute deadlines. Within 45 days of closing on the relinquished property, a 1031 trader must file a list of possible replacement properties with an intermediary. The second deadline occurs 180 days after the initial transaction. At that time, the exchanger must close on a replacement property, using equity equal to or more than the equity in the original property. Miss either deadline, and the IRS will send a capital gains tax bill.

(Simultaneous exchanges follow the simplest protocol. They proceed without an intermediary and involve a simultaneous exchange of real estate assets.)

In light of the deadlines and other issues that can complicate exchanges, a cottage industry of 1031 exchange advisors has emerged over the years. More importantly, the difficult time frame of 1031 rules means that if you can't find a swap, the transaction will take place regardless. “Whenever we go to sell a property and we have a gain in that property, which is the case 99 percent of the time, we'll attempt to do a 1031 to defer the gain,” says Jeff Berkes, senior vice president of strategic transactions for Federal Realty Investment Trust. Attempts do not always mean execution, however.

In fact, some potential exchangers may want to avoid 1031s altogether, since, in this time of heady real estate prices, some sellers will try to use the 180-day deadline as leverage to raise the price of the property. For that reason, warns Bruce MacDonald, president of Nashua, N.H.-based Net Lease Capital Advisors, “You never want to be in a situation where you must close on a particular property to protect your tax position.”

The Silver Lining

Despite its obstacles, shopping center owners continue to eye 1031 exchanges, simply because most sales and purchases offer opportunities to defer capital gains taxes via the channel. Federal Realty disposes of about six stabilized properties a year, and buys three or four with growth potential. “We sell more than we buy because we typically sell lower-priced assets and buy higher-priced ones,” says Berkes.

In April of 2001, for example, Federal Realty undertook an exchange involving its Williamsburg Shopping Center in Williamsburg, Va. The $16.7 million sale yielded a capital gain of $7.9 million. An intermediary held the proceeds while Federal Realty identified potential replacement properties. Five months later, Federal Realty acquired Friendship Center for $32.7 million. Proceeds from the Williamsburg sale, sheltered by the 1031 exchange, helped fund the acquisition.

Located in Chevy Chase, Md., an upscale suburb of Washington, D.C., the 119,000-square-foot Friendship Center offered better demographics and higher growth prospects, Berkes says.

The 1031 exchange is an excellent tool that allows deferred capital gains to fuel further growth, especially when that means acquiring bigger and better shopping centers. And although Berkes claims that the possibility of doing a 1031 “does not drive our decision making,” he does point out, “If a deal works within the time frame you have after selling a property, then we'll do it.”

For more information on 1031 Exchanges, visit the web sites of these advisory firms:

1031 Exchange Options
Lafayette, Calif.
www.1031exchangeoptions.com

AEI Fund Management Inc.
St. Paul, Minn.
www.aeifunds.com

CRIC Capital
Boston
www.criccapital.com

Capital Lease Funding
New York
www.capitalleasefunding.com

Cardinal Capital Partners Inc.
Dallas, New York
www.cardinalcapital.com

Commercial Net Lease Realty Inc.
Orlando, Fla.
www.1031replacementproperties.com

Cornerstone Capital Corporation
Dublin, Ohio
www.cornerstonecapitalcorp.com

Net Lease Capital
Boston, New York
www.netleasecapital.com

Newport Exchange
Boston
www.ne1031.com

Upland Real Estate Group
Minneapolis
www.nnnsales.com

Syndicated Equities Corporation
Chicago
www.syndicatedequities.com

Staubach Capital Partners
Dallas
www.staubach.com