Don’t Sell Your Investment Real Estate
Exchange It and You May Reap Many Rewards
by Patrick Brennan, MBA
If you own investment real estate and it’s worth a lot more than you paid for it, you might be able to reap many unexpected and valuable rewards using the “1031 exchange.” More about that later. But first let’s see if you’re the kind of person who could benefit from an exchange. Investment real estate includes any property that you own and can profit from, exclusive of your primary residence. This includes houses, apartments, office buildings, industrial parks, farms, even raw land. The key element is your purpose for owning it: investment. If you have such property, held for that purpose, keep reading.
Let’s say you’ve owned the property a while, and its value has increased greatly. You’re tempted to sell, but you don’t want to pay the tax on your gains. Fortunately, there’s an Internal Revenue Code section that’s been in place for over 50 years, allowing you to trade, or exchange your property for another piece of investment real estate and not pay the capital gains tax until later—how much later is up to you.
Suppose your investment property is a small apartment building that you paid $200,000 for 10 years ago. Today it’s worth $600,000. That’s 400,000 profit. If you sold the building, you’d pay tax on the profit—and if you depreciated the value (as nearly all owners do) you’d pay even more tax on the depreciated portion. Depending on where you live and your tax bracket, that could easily amount to more than 30 percent.
But thanks to Section 1031 of the Internal Revenue Code, you could trade that building for another investment property (say an office building). Ideally, you want the new property to cost more than all the equity and all the debt (if any) on the old building because the law says you can’t take any money out without paying tax. When you make the trade and replace all of your equity and debt, you don’t pay the taxes at that time. Rather, you defer them into your new property.
Drawbacks of the Standard 1031 exchange
As good as this transaction sounds, it has some drawbacks. Consider the following:
1. It might be hard to find a property that’s suitable for an exchange.
The new property has to be worth more than the old property—and because of recent price escalations, the price might be so lofty that you won’t find a property that produces a high enough yield to make it worth your while.
2. You still have to manage the new property.
After you’ve owned investment real estate for many years, you’re probably ready to be done with repairs, tenant problems, all the headaches involved in active management. If you’re getting up in years, this may be important to you.
3. You get no diversification in geography or type of property.
Exchanging from one building into another, larger one still means all your eggs are going to be in one basket. And if you exchange into an office building just when the office rental market is going soft, you could have a vacancy problem on your hands. It would be better to own several properties of different types located in different places. That’s "diversification." You can’t get that with one property.
4. Rules governing exchanges are complicated and penalties are harsh.
Section 1031 has a lot of provisions about how and when you must do the exchange, and if you don’t follow them exactly, it could cost you a lot of money. It would be foolish to do an exchange without hiring a professional to advise you.
The Accommodator
The accommodator’s role in your exchange is extremely critical. Since you cannot take receipt of cash upon selling out of your original property, the accommodator accepts your cash and holds it until the escrow closes on the second leg of the transaction (the acquisition of the new property or properties).
Accommodators, often referred to as "qualified intermediaries," are not regulated by anyone, so it is very important that you investigate the accommodator you intend to use in your escrow. I’d suggest you personally interview the people you intend to use and ask questions about fees, separate accounts, financial strength and experience. Some questions you may ask include:
- Are the investor’s funds held in separate accounts?
- How much financial strength does the accommodator have?
- How long have they been in this specific business and do they have references for you to call?
So, with all these drawbacks, rules and complications, would you still want to do a 1031 exchange? Possibly, because the potential tax breaks can be so valuable, it still might be worth the trouble. But wait. There is a certain type of 1031 exchange, called the Tenants In Common (or TIC) exchange that potentially eliminates or diminishes the drawbacks while still keeping most of the benefits. Here’s how it works.
Tenants In Common Exchanges
In addition to the rule requiring that the new property must have the same or greater amounts of equity and debt, there are time restrictions on 1031 exchanges. You must complete your new purchase within 180 days of closing your original escrow. You can identify up to three properties to exchange into within 45 days of closing your original escrow, but that 45 days is included in the 180-day total.
Historically, because of the strict time frames, investors were reluctant to enter into these types of exchanges, in fear of not finding a suitable replacement property or not closing on it within 180 days. After all, if you exceed these time frames, you’ll end up owing the tax! The Tenants in Common exchange can make your life much easier. The TIC is often used by smaller investors (those selling properties worth under $2 million) to exchange equity and debt into a large office building, shopping center or industrial park, and taking title as a tenant in common with other investors.
In March, 2002, the IRS released a set of 15 guidelines for such exchanges. This was an important step in the evolution of the TIC industry, because now the real estate firms and those involved in such exchanges had guidance by a regulatory body. To read these guidelines in their entirety, you can log on to www.apiexchange.com or www.irs.gov. Look for Revenue Procedure IRC 2002-22. I’d suggest that any TIC property you intend to exchange into include a tax letter of opinion by a reputable law firm, attesting to how well the structure of the transaction adheres to the guidelines.
Advantages and Disadvantages
With a TIC exchange, you potentially have significant advantages over a standard exchange. They include:
- The problem of finding a suitable replacement property within 45 days might not be as difficult. The company putting together the TIC property (the sponsor) does that for you.
- You conceivably get out of having to manage the property. In a TIC, professional managers are usually hired to take care of finding tenants, collecting rents, maintenance, etc.
- You may experience an upgrade in the quality of the property, since these usually are larger, institutional-type properties.
- These types of properties are likely to have better cash flow than you enjoyed in the smaller property you previously owned.
- You can get diversification by property type (office buildings, strip malls, industrial parks) and geographic location which can potentially lower your overall risk.
- There are additional tax advantages, including a "step-up" in cost basis and flexibility in reducing your estate taxes. Ask your CPA for an explanation of the discounting rules available with TIC ownership.
As with any investment, the TIC exchange does have its risks. The main ones are:
- Lack of liquidity. Since you own this property with other people, you can’t just pick up and sell the whole thing. Even though you do have a deed and title insurance, you might not be able to sell your interest readily.
- Vacancy. As with any rental property, when tenants move out, rent usually stops. This could be less of a risk in a large project, since there are many tenants. But a downturn in the business cycle can mean vacancies—and vacancies mean lower cash flow. The property management company may hold reserves to continue paying cash flow while the property is being re-rented, but that is not guaranteed.
- Unaffiliated owners. IRS regulations allow up to 35 tenants in common. This means you could own the property with up to 34 other people whom you don’t know and whom you might not necessarily agree with. There are other risks with unaffiliated owners as well. For example, one might declare bankruptcy. Then what? A good quality sponsor will take legal steps to protect you from such dangers.
- Less leverage. Typically, in TIC ownerships, the leverage is usually between 50-65%, whereas if you did it on your own, you could leverage much more—even 80-90%. Mortgage terms are typically shorter than in a property you finance yourself. This means the properties may have to be refinanced sooner, and if interest rates have risen in the meantime, you could experience higher lending costs, and thus lower income.
- While the IRS does not approve or reject transactions in advance, it does have the power to audit a TIC arrangement, and if it rejects the structure, you could lose some or all of the tax benefits.
Who’s Looking Out for Your Interests?
These transactions are subject to regulations issued by the federal government, state governments and the industry's own self-regulatory agencies. Firms and individual salespersons are required to follow these regulations, which include:- The transaction must be handled by a person, called a registered representative, who must be registered with both the National Association of Securities Dealers and the states in which the transaction will take place.
- You, the investor, must pass a test of "suitability." This means that before involving you in a TIC exchange, the representative must make sure that you are an "accredited investor" as defined by Regulation D of the United States Securities and Exchange Commission. The regulation requires that the transaction be well within your capacity to risk your capital and is consistent with your investment objectives.
- The sponsors of the deal must perform "due diligence." This means they have to inspect the properties, check the books, and generally make sure all the claims being made about the transaction are true.
The Wave of the Future?
In 2001, about one billion dollars worth of real estate was exchanged into TIC properties. In 2004, it's estimated that number will grow to over four billion dollars. This huge growth was spurred by several factors: —the dramatic increase in property values nation-wide; —the growing number of older property owners who want to get out of active management; —the IRS revenue rulings that have provided clear, defined guidelines to the industry; and most of all —the potential advantages this type of exchange has over the standard 1031 exchange. In my opinion, interest in TIC exchanges will continue to grow substantially as the strategy is publicized and more small investors seize the opportunity to own an interest in large real estate projects—something they can rarely do acting as individuals. If the Tenants in Common exchange sounds appealing to you, by all means look into it. To protect yourself, make sure you check all the facts, get a solid opinion from your tax professional, and most important, be sure you're dealing with a representative you can trust—someone who has experience in TIC exchanges and whose references you can check. Then relax, collect your cash flow and let someone else do all the work.