FEATURE ARTICLE, MARCH 2005

1031 EXCHANGES: THE NUMBERS ADD UP
Maximize your investment options, returns with 1031 exchanges and tenant-in-common investing.
Marc Paul

Paul

Investment real estate offers distinct advantages other investment instruments cannot. One well-known benefit, depreciation, creates some tax relief. The ability to leverage a property acquisition with mortgage debt can create cash flow. With principle reduction, an owner’s equity in the property increases. Most importantly, the 1031 exchange of real property offers a chance to defer taxes indefinitely.

Real estate purchases executed as 1031 exchanges afford a special opportunity to defer capital gains taxes. For owners of real property, only the 1031 exchange provides a method by which to sell property today and reinvest the profits up to 6 months later, deferring taxes until some future date the investor can control.

Over the past 7 years, commercial real estate investors have realized one of the most dramatic increases of property value in recent memory. Quality investments have become harder to find. Investors are looking for new avenues for their exchanges. To take best advantage of current favorable conditions, commercial real estate owners and investors need to understand the basics of 1031 exchanges and how the new world of TIC ownership works.

1031 Exchanges

By use of a 1031 exchange, an investor may sell a property today and reinvest the profits up to 6 months later without having to pay capital gains taxes at the time of the sale. Taxes are deferred to a future date that the individual chooses. In the 1984 Tax Reform Act, Congress approved of 1031 exchanging and required that the investor identify his “like-kind” trade property within 45 days and complete the exchange 180 days after the sale of his property. The 1986 Tax Reform Act sparked rapidly growing interest in the use of 1031 exchanging.

As recently as March 1988, restrictions deriving from interpretation of the 9th Circuit Court of Appeals’ ruling on the T.J. Starker/Crown Zellerbach exchange limited use of this investment procedure, but regulations issued in 1991 validated the used of the 1031 exchange on a national basis. In March of 2002, the I.R.S. issued Revenue Procedure 2002-22, which gave investors and sponsors further guidelines on how to transact successful, compliant TIC 1031 exchanges.

Like-Kind Property

The Internal Revenue Code Section 1031 (a) (1) states that “no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment.” Any kind of property held for investment can be exchanged for any other like-kind property that is being held for investment, and the investor will be allowed to defer paying capital gains taxes. Properties held for productive use in a trade or business or for investment would include raw land, motels, office buildings, apartments, warehouses and single-family rentals, to name a few. Any combination of such real estate can be exchanged. In other words, an apartment complex can be exchanged for an office building, a warehouse for a motel and raw land for a single-family rental. This crossover investing has driven up the prices of all kinds of properties so high that a single small investor may not be able to invest in his or her own neighborhood. Competition in the Southern California market has driven prices up, and many investors have moved to markets such as Nevada and Arizona. Over time, prices in these markets also rise, so that small investors are hard pressed to find ways to exchange properties.

TIC Investment Structure

Completing a 1031 tax-deferred exchange into a TIC co-ownership position offers an attractive alternative to sole ownership. The small investor can own an undivided fractional interest in an institutional-grade property and receive a pro-rata share of the income, tax benefits and appreciation, retaining the same ownership rights as a sole owner. TIC 1031 ownership makes it economically feasible to identify and acquire an ownership interest in several properties instead of one, thereby decreasing risk through diversification. For example, a TIC owner could split $500,000 in 1031 exchange equity into two $250,000 TIC co-owner positions in two different properties.

TIC Sponsors

Investors are urged to perform due diligence and research to ensure that they choose a reputable 1031 Exchange /TIC sponsor whose expertise and experience in various markets and types of properties provide the investor with confidence in 1031 investment decisions. Further, determine whether the TIC sponsor’s investment objectives for both the sponsor company and the property offering match the investor’s own aims. By practicing the same wise investment habits required in all transactions, investors small and large can realize financial goals not attainable by other types of real estate ownership.

Marc Paul is the president of SCI Real Estate Investmentsin Los Angeles.

©2005 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.