It's an understatement to say that the 1031 exchange has become a driving force in commercial real estate sales transactions. On the West Coast, an estimated 80% of all deals involve exchanges, which enable investors of all sizes to defer the dreaded capital-gains tax by snapping up other pieces of property of equal or greater value. Tax specialists say that the volume of 1031 exchanges nationally has risen 25% over the last three years.
What's really catching fire is the tenant-in-common (TIC) transaction, which enables exchangers to buy into portions of an investment property. While the TIC structure has been in use since the 1990s, new IRS guidelines issued in 2002 clearly have accelerated its growth (See related story, page 49).
“There has been an overabundance of capital out there in recent years and a shortage of replacement properties because there's been a lot of asset churning,” says Guy Ponticiello, senior vice president of the capital markets group at Jones Lang LaSalle in Chicago. “TICs are filling a void.”
Growing Menu of Options
Before TICs became popular, many replacement purchases were limited to “vanilla” properties such as stand-alone fast-food restaurants, video and drug stores because these best fit the modest-sized investor's profile, says Steve Regenstreif, vice president and senior director of the national retail group for Marcus & Millichap.
But the TIC has become a problem solver. In a highly publicized deal in 2003, 31 investors bought into a TIC pool to purchase part of the $148 million Puente Hills Mall in City of Industry at $1.8 million per share, with a larger investor assuming the balance.
Soon after, the $138 million Torrance Crossroads shopping center was divvied into eight varying parcels and sold to seven private investors and one institutional investor. A lone investor would have paid about $107 million for it, says Rich Walter, president of Irvine, Calif.-based Faris Lee Investments, which brokered the deal. A similar TIC format will be used by Coventry Real Estate Partners later this year to sell the $54 million Plaza at Puente Hills center across from the mall.
“This approach allows smaller investors to get in at a much better price, plus it creates additional value, mostly through marketing technique,” Walter says. “There's a substantial amount of pent-up 1031 capital looking for this kind of investment.”
TICs also buffer owners from operational headaches because the replacement properties are usually fully occupied with triple-net leases in place. “A lot of those TIC investors are happy to get out of more management-intensive real estate and into more passive investments,” says Louis Weller, principal at Deloitte & Touche National Real Estate Tax Services Group in San Francisco. “They're happy to know that their days of fixing toilets are over.”
Aging Baby Boomers heading family real estate trusts also are looking to simplify matters for their heirs by lifting the operational burden via the TIC, says Regenstreif of Marcus & Millichap. “Some Baby Boomers view TICs like they would a bond,” adds tax and real estate attorney John Napoli, a partner in New York-based Seyfarth Shaw. “It's a stable investment with a reliable long-term yield.”
Non-TIC 1031 retail opportunities are dwindling, says Regenstreif. “Three years ago, many of the Office Depot, OfficeMax and Staples buildings were for sale, but that's slowed down. A lot of major corporations are retaining their real estate because the cost of capital has been so low.”
In a 1031 exchange — also called a property flop — investors have 45 days to identify three potential replacement properties and a 180-day period that runs simultaneously to the closing. Exchangers must reinvest all proceeds, and a third-party intermediary — also known as an accommodator — must hold the monies in trust.
Equity held by the investor in the new property must equal or exceed the equity held in the previously owned property. Exchanges can range from a simple two-property swap to a multi-legged, multi-property deal that involves a “construction” exchange or a “reverse” exchange, where an investor buys the replacement first before selling the exchange property.
Rand Sperry, CEO of Sperry Van Ness, recounts a succession of personal 1031 Exchange investments he started in the 1990s when he bought a weathered shopping center, Dove Canyon Plaza in Rancho Santa Margarita, Calif., for $2.8 million.
“People made fun of me and said, ‘You're an idiot. You must not know anything about retail,’” Sperry recalls. “But I knew it cost about $13 million to build, so it was a no-brainer because it was well under replacement cost. We fixed it up and methodically leased it up, then sold it for $8 million. Then I bought two other buildings in an exchange in Montclair and Riverside for $5 million each.”
Each of those buildings has risen about $2 million in value. After they are fully depreciated (for tax purposes), Sperry will exchange the buildings and “we could end up with $20 million in assets in about a 10-year span,” he says. “Most folks could live pretty well off that.”
While investors from Main Street to Wall Street are wising up to the tax-saving properties of the 1031, some potential exchanges still slip through the cracks. A panicked New York investor recently placed a distress call to the Investment Exchange Group, based in Denver. The woman had just sold an investment property for about $5 million that she had originally acquired for $1.25 million.
Nice problem? Well, it appears no one bothered to tell her about a 1031 exchange, which would have enabled her to roll over the sale proceeds into another investment property, tax deferred. “Her realtor didn't tell her about 1031, her attorney didn't tell her about a 1031, so she took a $4 million capital gains hit and will face a million-dollar tax bill,” says attorney Dan McCabe, president of the national 1031 intermediary firm Investment Exchange Group. “That might be grounds for malpractice.”
Why have 1031 exchanges historically been more prevalent on the West Coast? Weller of Deloitte and Touche theorizes that the real estate booms in the West in the 1960s, 1970s and 1980s “made investors more entrepreneurial. Planning in the East is driven more by corporate financial people and attorneys, as opposed to real estate people.”
Mirroring industry growth, the Federation of Exchange Accommodators (FEA), an intermediary trade group, has grown from about 100 members in 1997 to over 300 currently, says David Kuns, vice president of Los Gatos, Calif.-based Starker Services and an FEA board member. In fact, the FEA created a new Certified Exchange Specialist (CES) designation less than a year ago to cater to the growing throng.
The 1031 is no longer just a rich man's domain. “The vast majority of exchanges throughout this country — about 90% — are done by John Q. Public,” Kuns says. “You see them selling a rental home in Schenectady and rolling it over into a four-plex.”
Depending on the complexity of the transaction, accommodators can be reasonably accommodating in price, charging anywhere from $250 to $3,000 for simple transactions to between $8,000 and $13,000 for more complicated deals, says Ponticiello of Jones Lang LaSalle.
For all its popularity, the 1031 industry is fraught with challenges and complexities. The number of TIC opportunities, for example, remains relatively few, says Seyfarth Shaw's Napoli. There can be as many as 34 partners in a TIC deal and all must be in accord with the purchase price, financing, renewal of the property's management agreement and lease terms of tenants, he says.
Large institutional investor programs are regularly outbid by private and high-net-worth investors seeking 1031 TIC deals. TIC buyers are often willing to take a lower yield on a property than a single owner who will have to spend much of his waking hours managing and updating the property, Napoli says.
The 5th Annual Wachovia National 1031 Exchange Seminar in mid-May in Atlanta drew attendees from coast to coast who were seeking solutions to complex questions. One hot-button topic was 1031 partnership disputes, says presenter Derrick Tharpe, vice president of Wachovia Exchange Services in Winston-Salem, N.C.
“What happens when some partners want to do a 1031 and others don't?” mused Tharpe, who advises attorneys, accountants, bankers, and clients on exchanges. “People are curious about when they can make disbursements to those who don't want to exchange, and how they can do it so as not to collapse the partnership.”
Some solutions violate the law, Tharpe says. “The euphemism in that situation was drop until you swap, which means you just drop the existing partner out of the exchange. But that's where you can get in trouble.” In most cases, it's best to issue an installment note to the exiting partner after the exchange, who can then take the payout, he says.
Some firms, such as For 1031 LLC, which was formed in October, matches up TIC deals with exchangers' debt-to-equity ratios. “If you have a client coming out of an eight-plex who has $400,000 in cash and $550,000 in debt, it's hard to replace it,” says Pete Johnson, vice president of the Boise, Idaho-based firm. “But we're able to offer varying loan-to-value ratios.”
Sometimes the hourglass just runs out. Aasia Mustakeem, a partner in the Atlanta law office of Powell, Goldstein, Frazier and Murphy, represented the sellers of two office structures who were spurred into a rush sale by a group of 1031 exchangers that needed to buy the pair of buildings quickly to get under the 180-day wire. The two other exchange properties they'd identified to the IRS had been sold out from under them and they had quickly become motivated buyers.
“There is a lot of due diligence involved in one of these deals, and we had to squeeze three months of work into a 30-day closing window to make the 180-day limit,” says Mustakeem. “It's a good thing it wasn't an older property because the due diligence would have exceeded that [time frame].”
When the minimum federal tax on capital gains from a property sale was reduced last year from 20% to 15%, experts speculated that investors would be tempted to cash in their assets, and that 1031 activity would dip. Not so, says accommodator McCabe. “Few are saying, ‘I'm going to go ahead and take a hit.’ It's tax free as long as you're playing the game, and most people have stayed in.
“For most of us, it's a retirement type of income stream, just like a 401(k) or IRA,” McCabe continues. “It's the idea you're moving up the food chain. You start with a duplex, move on to a four-plex and eight-plex, you get your depreciation out, and then work your way up to a 40-unit complex.”
Russell Brenner, managing director of Chicago-based Syndicated Equities Corp., a real estate investment firm specializing in 1031 exchanges, says all the new blood in the 1031 arena has more than compensated for the few who've cashed in. “Even in light of the capital-gains tax cut, we have still seen a tremendous surge in activity, in part because of all the press and publicity surrounding 1031s.”
John McDermott, national director of office and industrial properties for Irvine, Calif.-based brokerage and investment firm Sperry Van Ness, says the company has “seen the (1031 exchange) pie get bigger and bigger with each passing day. We're seeing second and third transactions for the same clients. Like the stock market, values will go up, but unlike the stock market, they won't go away.”
Because pension funds don't pay traditional real estate taxes, they really can't capitalize on 1031s. But REITs do use them for two prime reasons, says Weller. The first is to preserve capital by recycling proceeds from property sales rather than being required to distribute them to shareholders. The second is to keep gains on property sales from being allocated to investors, who had originally contributed the sold properties to the REIT.
REITS also are finding ways to entice individual investors through a 1031-721 exchange, including Denver-based Dividend Capital Trust. Using 721, the REIT offers individual investors an opportunity to buy a replacement property and later exchange it for operating-partnership units in Dividend Capital. However, a downside is investors lose the ability to keep exchanging after the conversion.
In their zeal to make a tax-deferred exchange, some investors may enter into a property that's a bad fit with their investment goals. Stephen Owen, a Washington tax attorney who chairs the Tax Group of Piper Rudnick, warns that “the tax tail should not wag the dog in the exchange area.”
While there are obvious tax benefits from a 1031, “taxpayers must make sure the replacement property is a solid investment separate and apart from the tax benefits of the exchange.” In recent years, clients have been challenged to find attractively priced replacement properties, Owen says.
“But ‘swap until you drop’ is certainly where the industry is headed,” says Ponticiello. “The 1031 allows you to get into larger and larger assets and enables you to build wealth pretty quickly.”
Recent IRS “private-letter” rulings have cleared the way for more investors to construct their own 1031 exchange replacement properties, literally creating new opportunities for entrepreneurs who were facing a shortage of reinvestment properties.
Issued last summer and late 2002, the rulings technically apply only to the taxpayers who requested them. But financial advisors and investors unfailingly adopt such rulings as guideposts, say 1031 experts. Though a fast-food restaurant or other quickly built structure may fit more neatly into the 180-day replacement timeframe in a 1031 exchange, these so-called improvement exchanges now offer enough flexibility to allow a broader spectrum of construction possibilities.
Here's how it works: A real estate investment trust (REIT) wanted to develop a $200 million shopping center on the East Coast as a 1031 replacement property for several older centers that it wanted to sell, says Louis Weller, a principal at Deloitte & Touche's national real estate tax services group in San Francisco. Because construction would take a couple years to complete, the REIT would miss the 180-day deadline.
But by using an intermediary, also known as an Exchange Accommodator Titleholder (EAT), to buy the land and own it during construction, the REIT could sell the old centers before it bought the new center in an arrangement that satisfied both the IRS and the REIT, Weller says.
Many investors used the improvement exchanges, also called construction exchanges, before the ruling, but did so with trepidation until the issuance of the private-letter ruling. The rulings also addressed the potential for conflicts of interest, and in effect gave the green light to investors who wanted to build replacement properties on land already owned by a close affiliate.
Improvement exchanges can be done on unimproved lots, or include additions to existing buildings, provided that they create enough value to constitute an exchange. A taxpayer can't construct improvements after taking title to property, however.
There are other caveats. Due to the potential for construction delay, a standard improvement exchange can leave investors shortchanged, says Steve Regenstreif, vice president and senior director of the national retail group for Marcus & Millichap. “If it's only 80% to 90% ready (when 180 days elapse), the IRS will ultimately give you credit toward only portion of the project completed.”
Thus far, developers and investors have been relatively slow to take advantage of the ruling, he says.
The two rulings have followed a litany of other investor-friendly 1031 clarifications in recent years by the IRS. In 2002, the IRS said investors could buy just a portion of a property for their replacement buys, creating a new universe for buyers who had been handcuffed by the scarcity of compatible “like-kind” properties available.
Two years prior, the IRS ruled investors could buy replacement properties even before selling their exchange properties. The flexible “reverse exchange” was officially born, removing some of the selling urgency from 1031 deals. Today, reverse exchanges are common.
— Steve McLinden