Want to Trade? Volume of 1031 Exchanges On the Rise

Date: 06/06/2014

With changes in tax rates and commercial real estate fundamentals continuing to improve, 1031 exchanges are growing in popularity again. Even lower Class B and C properties are getting some attention from investors. Still, despite their increasing prevalence, 1031 exchanges are not to be underestimated: adhering to the rules and best practices in the process is key.

I recently sat down with Ricky Novak, CEO of Strategic 1031 Exchange Advisors, in Studio One and we discussed advanced 1031 strategies.

Pro Tips

1031 exchanges permit an owner to defer the tax associated with a property sale if the owner identifies within 45 days and then acquires a similar or “like-kind” property within 180 days. The property target must match or exceed the sale price of the property the investor sells. If the price falls short, the investor has to pay tax on the shortfall.

With debt still somewhat difficult to secure, investors looking to complete exchanges must be organized from the very start.

“Investors have to keep in mind that the lending process takes longer than it used to,” Novak said. “Pre-qualification should be done before selling a relinquished property to make sure an investor qualifies and is able to secure debt.”

Finding a good qualified intermediary also is critical, Novak said. QIs that don’t follow the rules by backdating identification letters or by releasing funds improperly can trigger an IRS review of their activities. If the QI is found not following the rules, the IRS can then invalidate all exchange work the intermediary has done. Therefore, it’s a good idea to ask for references, along with the right questions, when vetting a QI.

Uptick in Volume

The volume of 1031 exchanges has returned to 2005 levels, Novak said. It’s a big jump from 2010, when transaction volume was down 90 percent. After the downturn, investors were only interested in core, Class A assets, he said. Now, that’s trickled down into Class B and C properties.

The uptick in volume can be attributed to the significant change in tax rates, Novak said. “If you look at long-term and short-term gain, a lot of states have increased state rates and there’s also a 3.8 percent investment income tax,” he added.

Clients who are selling assets they have owned less than a year are facing tax rates upwards of 50 percent, Novak said. Even if they’ve owned an asset for more than a year, tax rates are still often above 30 percent.

The pool of buyers for 1031 exchanges has grown as well. Private equity funds, individual taxpayers and family offices all have entered the arena. Additionally, foreign investors are making a play for real estate in the United States.

Kinds of Exchanges

Different types of 1031 exchanges can take place, depending on whether the properties involved are traditional commercial real estate assets, second homes or construction projects, Novak said. Investors can also participate in a reverse exchange in which investors purchase the replacement property before property to be relinquished is sold.

1031 exchanges can be used internationally as well, so long as the investor is a U.S. taxpayer, he said. The key to international exchanges is that the exchange has to be a U.S. property for a U.S. property or an international property for an international property. For example, someone who pays U.S. taxes but lives in the U.K. can trade a property in the Netherlands for one in Italy.

An investor who wants to do an exchange on a second home has to prove that the property is an investment and not primarily for personal use, Novak said. “There’s a big gray area for second homes,” he said. “The facts and circumstances are important. If you can, you should rent it out for a year. That way, you aren’t taking a risk should you be audited by the IRS.”

Construction exchanges are perfect for merchant builders, Novak said. Merchant builders build an asset, flip it and move on.

For example, construction exchanges are beneficial when an investor who has an $8 million property finds a $6 million property that needs about $2 million of work. Since the value of improvements count toward the replacement value, it’s a good trade, he said.