Crafting Custom Real Estate Solutions for Your Unique Goals, Part 4
Throughout this series, we have discussed refinancing, sale leaseback and installment sales. Each offering its own unique advantages and disadvantages. What all three have in common is a highly appreciated asset and while this is exciting you now have a tax “problem”.
In Part 4, we are taking a closer look at a Tax Deferred Exchange, also known as a 1031 Exchange. For owners who wish to redeploy equity to expand their portfolio or move their company to a more efficient facility without incurring a taxable event, a 1031 exchange is a great option. The Internal Revenue Code 1031 tax-deferred exchange provision is perhaps the most widely used tax mechanism in commercial real estate. Investors of all types and sizes utilize it to expand portfolios and redeploy equity to maximize returns. On the other hand, owner/users can utilize the tax-deferred exchange to acquire facilities that have the locational and functional components that reflect the current and future needs of their businesses. Changes in the way properties are used is common and it’s not just a matter of needing more or less space. Business models change for a variety of reasons and users often find that the building that once fit their needs perfectly has become inefficient and obsolete.
The rules are clearly defined and strictly enforced, but specialized assistance accessed through real estate accommodators is readily available to make sure that transactions are completed within the IRS guidelines.
In an exchange, the down-leg (currently owned property) is sold with the title and proceeds held by an accommodator until the up-leg (new property) is in position to close. You have 45 days to identify the replacement property and 180 days to close escrow on the up-leg and it has to meet the “like-kind” rule, which is defined as property held for investment, trade or business. The rule is broad enough for investors to exchange into a wide variety of alternative investments and defer all or a portion of the state and federal taxes that would otherwise be due.
Investors who have built significant equity in their down-leg property have the option of acquiring one or multiple properties of greater value by using the leverage afforded through low interest rate financing. Other investors who own properties with low cashflow, such as vacant land, can exchange into leased assets that offer monthly income they can use to service other debt or to supplement retirement income. Exchanging into several properties in different product types in multiples markets offers a great opportunity for investors looking to diversify their portfolios and decrease overall risk.
A common strategy among long-term investors is called “Swap Until You Drop”. These investors are tax adverse and do not plan on cashing out so each time they sell they do a 1031 exchange and defer the taxes. They keep repeating this process until they die at which time, their heirs get a step-up in property tax basis. If the heirs decide to sell, they don’t pay any property tax gains OR they can continue the process.
It’s worth noting that demand from businesses to own their real estate, rather than lease, is at an all-time high. This was the case pre-pandemic and now post-pandemic. So, any current owner/user looking to sell (exchange or not) need not be concerned with the salability of their existing building. The challenge is in acquiring the new property because supply falls well short of demand in all sizes and property types. There are a variety of reasons for this and a topic I will tackle is a separate post.
Now that we understand a 1031 and the benefits it provides, let’s play this out another way. You sell your property and are unable to identify a suitable replacement property. Is an outright sale all that bad? It depends on your perspective. At today’s prices, long-term owners can use a portion of their windfall profit to pay state and federal taxes and still end up with a handsome profit. On the other hand, paying up to a third of sale proceeds on taxes is just too much for some owners to stomach. The idea of giving away that much profit to non-participants who did not share in the risk is enough to give anyone pause; however, those who can look past the reality of high taxes see things a little different. When you remove the emotion and look at the after-tax internal rate of return on the original down payment, the return is so high that it makes good sense to sell, pay the taxes and move on. The massive run-up in prices is an opportunity to pay the taxes with “funny” money, meaning dollars realized by a price spike that you may have to give all or a portion of back in the event of a correction. Additionally, they also know that a major chuck of the tax is based on the recapture of depreciation write-offs, a number that will not change no matter what price the property sells for. Lastly, consider the qualitative aspect to a traditional sale. By realizing a profit, your taxes are paid, investment risk decreases, and the after-tax proceeds are yours to keep. You can finally buy that boat, travel the world or set up a college fund for the grandchildren. Yes, the numbers are important and it’s prudent to maximize returns and keep taxes low, but the truth is you can’t take it with you and there comes a time to take chips off the table and walk away ahead. The choice is yours!