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RAISE REAL ESTATE,
TABLE TAXES
1031 exchange investors cash in on low interest rates
and built-up equity.
Stephen Stein
It’s no secret that the combination of low interest rates
and strong buyer demand has increased commercial property values
— substantially in some areas. As a result, owners of
investment property struggle with the dilemma of how to take
advantage of built-up equity in their income-producing properties,
while delaying payment of capital gains taxes. The current market
environment has encouraged private investors to upgrade or reposition
their real estate holdings.
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Stein |
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With proper guidance from a tax professional or attorney, well-informed
investors are utilizing the 1031 provision in the Internal Revenue
Code to meet the dual objectives of trading up to larger or
higher quality properties while deferring capital gains taxes.
Some investors, especially aging baby boomers, are trading into
properties that are less management intensive.
While there are three basic types of exchanges—simultaneous,
reverse and deferred — the latter type accounts for 95
percent of these transactions. When selling an investment property,
the code gives a seller 45 days from the close of escrow of
the relinquished property (“down leg”) to identify
up to three replacement properties (“up leg”), and
an additional 135 days to close escrow on at least one of the
identified properties. The seller must contract with a neutral
third party, known as a qualified intermediary or accommodator,
to hold the funds from the sale of the relinquished property
and to purchase the replacement property for the seller’s
benefit. Completing this process allows sellers of real property,
held for investment purposes, to delay or defer the payment
of capital gains and recapture the depreciation tax benefit.
Deviating from the process described above may result in tax
consequences or costly penalties.
So where is most of the current 1031 exchange activity occurring?
Much of the activity is taking place in high-growth markets
in the western states. According to most economists, the West
— California in particular — is experiencing substantial
immigration of new residents from eastern states and Mexico,
thus creating a tremendous positive impact on investment real
estate. Depending on various factors respective to each property
type, this demographic trend spawns different opportunities
that are attracting investors.
The replacement properties coveted by most investors are apartments
and retail investments, and most recently there has been a strong
demand for single-tenant triple-net-lease properties such as
fast-food restaurants and drugstores. Also, with the recent
changes in the tax code, 1031 investors are now able to exchange
into tenant-in-common (TIC) investments that provide the ultimate
in management-free income property ownership.
Most exchange buyers prefer to stay in markets with which they
are familiar, although the more adventurous have roamed to unfamiliar
territories at the lure of perceived greater opportunities or
higher yields. With single-tenant net-leased properties, most
investors will consider opportunities in marketplaces across
the country as this type of investment requires little or no
management, giving rise to the term “armchair investment.”
While location is always critical, the quality of the tenant
and the lease play an equally important component in the decision-making
process. Investing in single-tenant net-lease properties takes
the mystery out of your yield on the front end. With some other
property types, returns are a moving target. By moving capital
to single-tenant assets, investors are adjusting their financial
strategies, with emphasis on capital preservation and cash yield.
A recent transaction illustrates how an investor utilized a
1031 exchange to move from one area to another in order to capitalize
on a perceived market opportunity. The owner of a nine-unit
apartment property in the South Bay region of Los Angeles sold
his property for $855,000, or $95,000 per unit. Having bought
the property 3 years earlier for $585,000, the seller netted
more than $210,000 after commission and closing costs. He added
additional money to his exchange proceeds and purchased a larger
replacement property in Phoenix at a per unit cost of $69,000.
The buyer believed that rents in Southern California had almost
peaked and decided to exchange into Phoenix because he was convinced
that Phoenix would offer tremendous upside as the market recovered.
At a per-unit difference of $26,000, the buyer felt that Phoenix
also offered better long-term value.
An example of an adventurer is that of a woman who sold a small
apartment complex in Los Angeles and a smaller apartment complex
in San Francisco. This investor wanted to eliminate the daily
management grind she was experiencing with small multi-family
properties. She decided to sell and take advantage of current
high prices being paid for apartments. This investor purchased
both properties at the right time and was prepared to take her
built-up equity and move it into single-tenant, net-leased investments.
Her requirements were simple: a strong tenant and a minimum
8 percent cash return. At press time, she was conducting her
due diligence on two single-tenant investments, one in Ohio
and the other in Indiana.
So where is the downside? That may lie in doing nothing during
these unprecedented times of historically low interest rates.
It goes without saying that interest rates will climb. Unfortunately,
investors’ cash return requirements will most likely increase
when other investments become more attractive as interest rates
rise. In this scenario, those that sit on the sidelines may
see their built-up equity slip away. For example, let’s
assume that buyers will accept the same cash return after interest
rates rise as they can achieve with today’s lower rates.
Now let’s look at the effect on an owner’s equity
using a net operating income of $100,000 and an investor’s
minimum cash return requirement of 6.5 percent. In order to
achieve that return, the buyer will use a 7 percent cap rate
in underwriting the value and secure financing at a 70 percent
loan-to-value ratio, with a 6 percent interest rate and 30-year
amortization. This will give the buyer in our example a 6.52
percent return at a purchase price of $1.43 million. But, if
interest rates climb 1 percentage point, the purchase price
would need to be $1.325 million in order for the buyer to achieve
the same cash return as a percentage of their down payment.
The seller would lose $105,000 in equity, or 7.3 percent in
value, simply because interest rates ticked upward.
While 1031 exchanges have increased in popularity, investors
should evaluate their own situations and objectives. The first
step is to have a qualified real estate agent evaluate your
property to determine market value and then discuss the tax
alternatives with your tax advisor. In some instances, it may
be worth taking the cash and paying capital gains taxes considering
the reduced rates enacted earlier this year. On the other hand,
an exchange may be the key to unlocking built-up equity and
providing the opportunity to expand a portfolio and create greater
wealth. The biggest mistake would be not knowing your alternatives.
Stephen Stein is a director of Marcus & Millichap’s
National Retail Group, specializing in retail investment properties
and 1031 exchanges.
©2004 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
from France Publications, Inc. For information on reprints of
this article contact Barbara
Sherer at (630) 554-6054.
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