“the first to apologize is the bravest – the first to forgive is the strongest- the first to forget to forget is the happiest”
by Keith O’Donnell and Mark M. Rubin Nov.Dec.15
Investment activity has been vigorous since the economic rebound, especially in highly stabilized markets, such as New York, South Florida, and San Francisco. A nearly 100-year-old Internal Revenue Code provision has seen a resurgence of popularity due to its immediate and long-term benefits to the investors who use it to structure deals.
The power behind IRC section 1031, often simply referred to as a “1031 exchange,” is that it is available to every investor, regardless of size, as long as the property has been used for business, productive use, or investment purposes. The code allows investors to defer capital gains and unrecaptured depreciation, and unlike many investment activities, it does not have a “sweet spot” or ideal range.
This discussion of how exchange rules came to be and why revocation would provoke a negative outcome for the general economy, as well as the real estate investment community, helps investors understand the overarching, long-term benefits of 1031 exchange transactions.
Promoting Economic Growth
Also known as a “like-kind” exchange, a 1031 exchange is a way of structuring the sale of an asset so that the seller’s profit or gain is not currently taxed. Instead, the asset being sold is replaced with another like-kind asset, which must be acquired within a relatively short timeframe.
From the time the relinquished property closes, the exchangor has 45 days to identify potential replacement properties and 180 days to acquire a replacement property. The entire transaction must be completed in 180 days, not 45 days plus 180 days. If the transaction is properly structured, the seller’s profit or gain is deferred to a future transaction date.
Investors of all classes use 1031 exchanges as a tax strategy to defer taxes when selling a property for a profit. When investors incur losses, they generally do not elect a 1031 exchange, as they often prefer to recognize the loss in the current tax year.
While the rules that apply to all 1031 exchanges were enacted by Congress in 1921, two primary purposes of the rules are more relevant today: to encourage active reinvestment into the economy and avoid unfair taxation as investors reinvest.
In short, 1031 exchanges were intentionally designed to increase the volume of business in the economy and promote growth. While real estate may have been the catalyst to the recent economic recession, it is also a leading indicator of strength of economy when it is trending positively.
Today’s Exchange Market
In today’s seller-friendly commercial real estate investment market, multiple buyers often compete to purchase available for-sale real estate assets. Such a climate benefits sellers, as it drives up the purchase price of their properties. However, in turn, if sellers are looking to reinvest in a 1031 exchange to mitigate tax implications, they may face the same competition on the buyer’s side.
Thus, 1031 investors are often willing to pay a market premium for the asset they are bidding on as they take into account their tax benefits as part of their investment return analysis. These buyers are also less likely to attempt to renegotiate the business terms during the due diligence period as they have to complete the transaction within a limited timeframe to defer capital gains taxes.
In addition, 1031 buyers are often attracted to off-market transactions to avoid a competitive process. An example of this recently took place in Boca Raton, Fla., a submarket of Palm Beach County that continues to attract investors seeking safe and stable commercial real estate yields. Avison Young’s knowledge of local assets and strong network of relationships with property owners in the market resulted in identifying an off-market property within 45 days to fulfill the buyer’s 1031 requirement. The $33 million sale of 595 Financial Center, a two-building, class A office portfolio totaling 116,000 square feet was purchased by Pinnacle Holdings in a 1031 tax-deferred exchange. Working with the seller’s agent, Avison Young closed the transaction within the buyer’s tight time constraints at a price nearly 10 percent below its previous sale price.
Investors have always needed to consider the potential for future increases in capital gain taxes when deciding to execute a 1031 exchange, as they face the risk of paying higher capital gains taxes in the future. Recent and potential capital gains tax increases, as well as expectations of interest rate increases, have added a wrinkle to the exchange practice. Today, more investors believe that the market may be peaking and are deciding to pay their taxes now rather than buying into a premium competitive market and running the risk of paying higher rates in the future.
The misconception is that 1031 exchanges only benefit investors going through the 1031 process because they can defer taxes on properties sold. However, if this was no longer the case, 1031 sellers might be more inclined to hold on to their properties, which could potentially slow down reinvestment into the economy.
Ongoing, robust investment sales activity can have benefits beyond the 1031 investor, by its impact on the job market, potentially contributing to the sustainability of certain industries. If sales were to decrease momentum due to a repeal or limitations on 1031 exchanges, banking, finance, legal, construction, and other real estate-related industries could feel a negative impact through job loss. Although the payment of taxes is deferred, significantly fewer jobs would have a much more detrimental effect, both within local markets and nationally. This outcome would be completely opposite of the stimulus that the economy — which some experts are saying is nearing the end of its current cycle — is dependent upon at this fragile state of the recovery.
Many commercial real estate brokers and investors remember a time not too long ago when the economy was uncertain, causing investors and their capital to sit on the sidelines, leaving sales at a standstill. Now with money and property movement in the market again, investors are becoming more swift and nimble when it comes to transactions, choosing options that generate more wealth over time.
The ability to reinvest 100 percent of equity builds cash flow and net worth significantly more than choosing to pay income taxes on properties after each transaction. It also compels real estate investors to continually exchange properties as they build equity. With the 1031 exchange remaining an available option to investors, the future of commercial real estate looks positive, evidenced by healthy sales activity benefitting the overall economy.
Keith O’Donnell is principal and Mark M. Rubin is vice president, Capital Markets Group, of Avison Young, based in Boca Raton, Fla. Contact them at email@example.com and firstname.lastname@example.org.
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