FEATURE ARTICLE, JUNE 2005

THE STATUS OF THE 1031 EXCHANGE
Western real estate players are no strangers to the tax-deferred approach to buying and selling commercial property.
Duke Runnels

Runnels

Why the West Coast?

The real estate boom in the West from the 1960s to 1980s made investors more entrepreneurial as they realized significant gains. These individuals are very attracted to 1031 exchanges because they want to defer their tax liability indefinitely. In many ways the West Coast has been more innovative than other areas of the country, and this holds true when discussing real estate investments. When the delayed exchange was approved as the result of the Starker case in the late 1970s, the West Coast was the first to embrace the opportunities that were created. This, perhaps, was due to two factors: 1) the large population located on the West Coast, and 2) the large concentration of these individuals who owned real estate.

Another reason the West Coast has traditionally seen more 1031 exchanges is due to the huge run up in value of West Coast real estate. In the past, the tendency of real estate investors was to acquire properties nearby. When it was time to exchange properties, they opted for other local or regional properties. However, these investors are now expanding their geographic horizons. Due to the large gain in value on West Coast properties, investors are experiencing significant challenges in finding quality developments on the West Coast for replacement properties. Often times they can achieve greater cash flow and returns on their investments in other parts of the country and 1031 exchanges aid in this process. By deferring the tax liability of the sale, investors may invest the entire net sale proceeds for their continued personal gain.

Lastly, there is a large quantity of qualified intermediaries (QIs) located on the West Coast. A QI is required by IRC section 1031 to hold the proceeds of the relinquished property until the funds are used to purchase the replacement property. The QIs have played a significant role in educating the public and raising awareness of the options associated with a 1031 exchange. With awareness came interest and with investor interest came a plethora of 1031 exchanges. But why are there so many QIs on the West Coast? Because many of the most substantial QIs are owned by title insurance companies headquartered on the West Coast.

Hot Properties

What types of properties are hot right now for 1031 exchanges? That depends on the investors’ goals and objectives. If, for example, the investors are mature individuals who have experienced a run up in value of their investments and are looking for investments with secure cash flow and minimal management, they tend to choose properties with triple-net leases and single or few tenants. Such investments are less management intensive, have a more stable cash flow and are often seen as a more secure investment option. Investors with more conservative goals are also attracted to industrial/flex or office properties with few tenants for the same reasons — a steady cash flow to supplement retirement or other income.

If, however, the investors are earlier in the “game” or more aggressive in their approach and willing to capitalize on risk, the successful management of that risk will yield them greater growth. Because these investors have a longer investment horizon to create and build wealth, they are more likely to consider properties with higher vacancy rates or below market leases. They may also be willing to take on more of the management responsibilities of the properties, and will consider apartment buildings or self-storage properties, all focused on wealth creation.

Unique Challenges?

With any investment there are challenges. The challenges faced by 1031 investors, companies and sellers are the same challenges faced by any owner or buyer of real estate. The biggest challenge is finding acceptable properties to fit the investment objective, regardless of whether it is a new purchase or a 1031 exchange. In today’s market there is an excessive amount of capital in comparison to the number of quality properties, spurred in part by the availability of low-cost debt.

Also, in many instances, individual investors are competing against pension funds or real estate investment trusts (REITs) to purchase properties. Because real estate continues to be an outstanding hedge against inflation, institutional investors (such as retirement funds) are increasing their real estate holdings. Real estate tends to be a very diverse investment, offering not only regional diversity but diversity in product type — increasing its reputation as a safer investment option. Institutional investors are very interested in safety due to the uncertain interest rate environment and world political instability.

The expectations of the seller can also lead to significant challenges. If investors are selling into an escalating hot market, many assume that they will be able to find replacement properties of the same quality for a cheaper price than the properties they are selling. Most investors are challenged to find such a property on the West Coast or either coast for that matter. When coupled with the time constraints of the 1031 exchange, these investors can make questionable decisions on replacement properties.

Does 5 Percent Make a Difference?

In 2004, the federal government lowered the capital gains tax from a property sale from 20 percent to 15 percent. However, when investors really take a look at the other taxes assessed when selling — such as recapture tax and state income tax — the total tax most pay is closer to 25 percent. The 5 percent reduction on the capital gains tax is not significant enough to cause people to want to sell now and pay the taxes, and the expanding 1031 exchange market has more than offset any drop-off from those investors who cash out of the market as a result of the lower federal capital gains rate. Additionally, if investors opt to sell and pay the capital gains, they could be facing the Alternative Minimum Tax, and no one can predict the ramifications that will have on the bottom line from a personal tax perspective.

Duke Runnels is president and CEO of FORT Properties in Los Angeles.

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