Behind The Trigger

A Fantas“TIC” Shelter

Taking Advantage of Recent Developments In 1031 Exchanges And Saving Your Clients

A Lot Of Money

By Michael D. Aguas

Perhaps you’ve been thinking about selling your commercial property. There are a variety of reasons why. In some cases, the sheer burden of management may be taking its toll. Maybe there’s a disagreement among partners. Whatever the reason, the thoughts of selling have crossed your mind. If you have owned your property long enough, you may wind up paying a significant amount of taxes on the gain of sale. Then again, you may be considering a like kind exchange. While this will save you money, you may have valid concerns particularly about finding suitable properties for replacement. Fortunately, you have other options. Read on.

A Trend Worth Following

The IRS states that “Section 1031(a) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment.” Enacted in 1921, this is one of the last tax shelters allowed by the IRS. While the taxpayer is alive, an exchange represents tax deferral. Upon death, that same exchange represents tax avoidance. Why? Because the property held in a 1031 exchange passes on with a stepped up cost basis. Regulations in the tax code were complex. It was common to obtain an attorney’s opinion letter to be safe that a transaction qualified as an exchange. This was simplified with the Omnibus Budget Act of 1990. Through that decade and particularly since 1996, the nation has seen the greatest surge in real estate prices. Sales or transfers of these properties created the largest capital gains in the history of real estate. Investors seek shelter and thus, the like kind exchange became a viable alternative. Trends in recent years suggest that the concept is spreading like wildfire. Reports show that 1031 exchange tenant in common transactions (explained later in this article) grew from $150 million in its infancy in 2001, approached $2 billion in 2004.

The Basic Rules of 1031 exchanges

The property to be relinquished must be considered a qualifying property. Qualifying property includes real estate used in trade or business, investment or income producing property. The replacement property must be like kind. The term “like kind” is rather broad in that a full interest can be replaced by a partial interest in property. An apartment complex can be replaced by an office complex. Improved property can be replaced by raw land. Properties that do not qualify include a personal residence, vacation homes, properties purchased for resale, construction fixer uppers for resale and land under development.

To reap the benefit of the deferred capital tax gain, there are a few key things to remember. First and foremost, the seller (who desires to participate in an exchange) cannot take constructive receipt. At closing, the qualified intermediary must receive the sales proceeds. If the seller receives a check for the sale, the transaction would disqualify an exchange. The seller must identify up to 3 potential replacement properties within 45 days of closing on the sale. Missing this deadline would disqualify the entire exchange. Other rules apply for those who want to identify more than 3 properties. The 1031 exchange must be completed within 180 days (from that same closing date). Finally, the seller should never change the manner of title during the exchange. Such change in the legal relationship to the property could jeopardize the exchange. For example, if a limited partnership is the legal owner of a commercial property and only one of the partners is interested in a like kind exchange, they should break up the limited partnership, re-title the property and maintain that title in the exchange. For these and other reasons, tax and legal professionals play critical roles in the structuring of successful exchanges.

There are three main types of 1031 exchanges. A simultaneous exchange occurs when both the relinquished and replacement properties are closed on the same day. A delayed exchange, also known as the “Starker Exchange” has the relinquished property closing before the replacement property. A reverse exchange has the replacement property closing before the relinquished property is sold.

The term “qualified intermediary” was used earlier. A qualified intermediary (QI) is a person who isn’t the taxpayer or a disqualified person. The QI is under contract via a written agreement with the taxpayer. Per the agreement, the QI takes and transfers the relinquished property, purchases the replacement property and transfers that property to the taxpayer. The Internal Revenue Code defines who is not qualified to be an intermediary. Realtors, attorneys and accountants who served the taxpayer in their professional capacity in the past two years cannot serve as qualified intermediaries. Otherwise, individuals can serve as intermediaries in an exchange. There are no licensing requirements. Therefore it is incumbent upon the client to make sure they understand the QI’s true area of expertise or run the risk of a disqualified transaction. There are a host of important questions clients need to ask before choosing a QI. In addition to the fees involved one needs to consider the QI’s bonding, capabilities, policies and reputation. An intermediary trade group, the Federation of Exchange Accommodators now has over 300 members and has created the Certified Exchange Specialist designation to upgrade membership qualifications and competencies.

Noteworthy is that there are a few disadvantages associated with 1031 exchanges. First is the fact that the taxpayer now has a reduced cost basis on the replacement property. Another consideration is the continued illiquid nature of the taxpayer’s asset. Selling a property outright without an exchange creates a liquidity event and provides the taxpayer with more options even after any gains are paid. Finally, a poor decision on the replacement property could result in more headaches and problems for investors.

The TIC Phenomenon

Until a few years ago, most investors looking for replacement property sought out similar properties. This approach came with several challenges. First is the issue of time. The 45 day rule is difficult enough, but as the dollar amount grows, the task of identifying a potential replacement becomes more daunting. Imagine putting a $20 million strip mall, currently under contract for sale, in an exchange program and knowing you have approximately one and a half months to find a replacement. Most would have started the process earlier, but with little familiarity on the 1031 exchange, many lose precious time. Further, the negotiations could be compromised when the seller of the replacement property learns of the 1031 exchange. Some investors also prefer to retire from property management. They are looking to move past the three “T’s” (tenants, toilets and trash). Property owners may not want the additional pressure of reviewing and renegotiating tenant leases on the replacement.

Now investors have another option that meets the IRC code that also addresses many of the aforementioned issues. Rapidly growing in popularity are the tenant in common (TIC) transactions which enables 1031 exchange candidates to buy into portions of investment property. Due to the difficulty of finding equal and offsetting properties for each investor, sponsors offer interests in larger real estate offerings to pools of investors in the form of TIC interests. In 2002, IRS “private letter” rulings gave investors opportunities to construct their own 1031 exchange properties which opened new possibilities for investors faced with an insufficient supply of potential replacement properties. It also allowed for investors to purchase a portion of property for their replacement purchase. This opened the doors to more buyers who were previously faced with a shortage of replacement properties to choose from. Like other alternatives TIC exchanges come with pros and cons. The advantages are noteworthy: the investor typically shares ownership in pristine property with Fortune 500 type tenants, smaller investors participate at a lower price, leases are negotiated on the investors’ behalf, clients receive dividends from that property, avoids any operational problems, and when the property is sold (commonly planned for 3 to 5 years after its purchase), the investor has three options: first, the investor can initiate another 1031 exchange, second the investor take all the proceeds from sale and third, the investor can execute a partial exchange. The main disadvantages are that if the wrong property is purchased, the investor has a substantial portion of his or her net worth invested in a problem asset. Also, this it’s quite difficult to get out of this investment. If the investor wants out, a new investor must purchase his/her interest in the property or the sponsor must be willing to buy back the interest.

Those who reflect on the 1980’s and the real estate syndications established back then should not be quick to generalize and dismiss TICs. Many of the syndications created in the 1980s were designed to produce short-term losses for tax purposes. TICs differ in that (1) they focus on the acquisition of property rather than the acquisition of a portfolio and (2) decisions to acquire such property are based on real estate fundamentals: location, prospects of appreciation and cash flows.

Make no mistake about it. This is no panacea. TICs are not suitable for many investors for a variety of reasons. Generally speaking, this is a better fit for older investors who can live off the dividend income received. The client should have sufficient liquidity before entering into such a transaction due to the difficulty of getting the capital out before a liquidity event. Another issue is the higher costs associated with the purchase of a TIC. These costs could offset the tax benefits of an exchange. It behooves the investment professional to conduct a thorough interview and due diligence before deciding that a TIC is the best alternative for a client. This investment may only be offered through a private placement memorandum (under Regulation D of the Securities Act of 1933) and individuals making this recommendation need a Series 7 or 22 securities license. The private placement exemption prohibits general solicitation to offer or sell securities on the basis that this is what differentiates a public from a private offering. Investors must be accredited and should have a net worth of $1 million outside of their primary residence.

REITs are also attracting individual investors via the 1031-721 exchange route. Through this approach, investors buy a replacement property then later exchange it for operating partnership units. The main advantage is a diversified portfolio of real estate holdings. The shares (of a publicly traded REIT) can be sold in the marketplace so liquidation need not be a cumbersome process. The main disadvantage is that the investors lose the ability to keep exchanging once the conversion is complete.

A Complex, But Real Solution For You

Although they are now growing in sophistication, many real estate investors are still very unaware of the concept of like kind exchanges. Those owning commercial and investment property for many years are forking over precious thousands (in some cases millions) because they never took the trouble to fully understand their options. You might argue that in the face of the lowest capital gains tax rates in history, the appeal might have somewhat lost some luster. Trends suggest otherwise. There are many rules and regulations attributable to like kind exchanges. The process can be overwhelming. As it grows in popularity more and more resources are created making the process somewhat more manageable. As baby boomers grow in age and the transfer of wealth accelerates in the 21^st century, tax, investment and legal professionals will be challenged by clients to know more about this matter. Talk to professionals who are well read on this issue. If you own commercial or investment property, make time to learn about the recent developments in 1031 exchanges and the benefits they bring to you.

About The Author: Michael D. Aguas is a Senior Regional Vice President with a privately owned, New Jersey based broker/dealer. As the national sales manager, he works with nearly 700 financial advisors on investment and estate planning issues. Most recently, he has been educating advisors and investment clients on the topic of 1031 exchanges. He can be reached at mdaguas@mac.com or by phone (845) 926-5650.

By Michael D. Aguas