Using Advanced 1031 Exchange Strategies to Improve Client Investment Returns By Greg Lehrmann, Attorney Greg Lehrmann, Attorney, is with Asset Preservation, Inc., a leading national 1031 Exchange Qualified Intermediary. Mr. Lehrmann, is the Texas Division Manager for the firm. For more information, call 800-282-1031 or visit apiexchange.com. Tax deferred exchanges continue to gain popularity in all commercial markets, but particularly on the East and West Coasts where property appreciation has been strong. This article examines some of the trends and provides insight into what to expect this year with regard to IRC 1031 tax deferred exchanges (1031 exchanges). Despite the 2003 reduction in the federal capital gain tax to 15 percent, commercial property owners are still performing 1031 exchanges at an increasing rate. Often the impact of depreciation recapture at 25 percent, plus the combined federal and state tax owed means that a 1031 exchange is a much better alternative. In fact, the value of a tax deferral becomes even more dramatic when comparing the purchasing power of an exchange and that of a sale. EXAMPLE: Assume an investment property owner sells a commercial property for $7 million. The owner originally purchased the property for $2 million. There is $1 million of debt and the property has been fully depreciated (assuming 80 percent of the property is depreciable). The investor has $5 million of EXAMPLE ONE: Depreciation Recapture: $1,600,000 (depreciation recapture) x 25% = $400,000 Plus: Federal Capital Gain Tax: $5,000,000 (capital gain balance) x 15% = $750,000 Plus: State Taxes: $6,600,000 x 5% = $330,000 Equals: Total Taxes Owed in a Sale: = $1,480,000 46
capital gain plus $1.6 million of depreciation recapture. The top federal tax bracket of 15 percent applies, and the state tax rate is five percent. BENEFIT OF IRC 1031: The major benefit of an exchange is not the actual savings but the purchasing power provided by this tax savings. The example above analyzes the value of a new property that could be acquired in an exchange versus by a sale. The comparison assumes an investor makes a 25 percent down payment and finances 75 percent of the property (75 percent loan-to-value ratio.) As this comparison illustrates, the investor who performs a 1031 exchange acquires $5,902,000 more real estate than the investor who sold and paid taxes! Tax-deferred exchanges are still a great way for investors to ratchet up their equity into more property and to increase the rate of return on their money. The challenge is to find good replacement property. Many owners are ready to take advantage of a great seller s market, but in order to make a good buy they may find themselves exploring cooler markets, says Jerry Alexander, SIOR, an industrial specialist with NAI Stoneleigh Huff Brous McDowell in Fort Worth, Texas. While most industrial owners prefer to stay within their realm of knowledge and limit their searches of replacement property to industrial projects, it is SALE EXCHANGE Equity: $6,000,000 Equity: $6,000,000 Taxes Owed: $1,480,000 Taxes Owed: $0 After-Tax Equity: $4,520,000 After-Tax Equity: $6,000,000 x 4 x 4 New Property: $18,008,000 New Property: $24,000,000 important that all investors know that any property that will be held for productive use in a trade, business, or investment qualifies for tax-deferral treatment under Section 1031. Another unique investment option for 1031 investors seeking diversification in addition to professional management and institutional grade property involves a 721 exchange, through which the investor can receive interests in a diversified REIT portfolio on a tax-deferred basis, says Jill Mozer, Attorney, Regional Vice President for Dividend Capital Exchange. The details of this type of transaction are beyond the scope of this article. $2 BILLION $1.5 BILLION $1 BILLION $500 MILLION 0 Fractional Ownership/ TIC Programs More commercial investors are exploring the benefits of tenantin-common ( TIC ) programs and more owners and developers are seeking ways to capitalize on this booming level of interest and demand. A TIC program represents a fractional ownership interest in commercial real estate along with other co-owners. The TIC investor acquires an undivided interest in a much larger property from a TIC Sponsor and the pro rata income, tax benefits, and appreciation of the property. The TIC agreement establishes the governance of the property and the decisions that require a vote by the property owner. The advantage of TIC programs is that they allow smaller investors a share in the benefits of a larger institutional-grade property, such as an industrial building, shopping center, office building, distribution facility, or shopping center anchored with well-known credit tenants. The investors benefit from having a relatively passive cash flow and Spring 2005 professional report 47
professional property management in place. For investors performing a tax deferred exchange, the TIC sponsor can often carve out a fractional ownership interest that meets the exact equity and debt requirements needed for full tax deferral. Furthermore, because many of the TIC sponsors own the replacement property, they can provide the investor with the ability to identify a fractional ownership interest near the end of the 45-day Identification Period. This can mean the difference between preserving tax deferral or being forced to pay the capital gain taxes and depreciation for failure to meet the strict time requirements provided by IRC Section 1031. The IRS released Revenue Procedure 2002-22 to address some TIC program issues. Although this did not create a formal safe harbor for these transactions, TIC Program sponsors have generally modified their programs so they adhere to many of the paramenters specified in the Revenue Procedure. Although the minimum equity varies depending on the property and the number of co-owners, many sponsors have stated that their minimum investments range from a low of $100,000 to a high of $750,000. Loans typically range from five to 10 years. It is important that investors have their tax and/or legal advisors thoroughly review all aspects of any TIC program because the programs vary considerably, and some TIC sponsors have more experience than others in purchasing and managing these sorts of properties. The interpretations EXAMPLE TWO: The exchanger disposes of the following property: Phase I Sales Price $1,000,000 Old Debt -200,000 Cost of Sale -70,000 Net Equity $730,000 The amount to spend to defer 100 percent of the tax: $200,000 in debt relief plus $730,000 in net equity = $930,000. The exchanger acquires the following property: Phase II Lot Purchase (Financed) $200,000 Capital Improvements 730,000 New Exchange Value $ 930,000 of these laws, in the industry and among legal experts, is in a state of flux. Many authorities believe these investments constitute both securities and real estate interests. Developers seeking to set up these programs to attract capital should locate counsel that is very familiar with the securities and real estate aspects of this almost daily-evolving area. Reverse and Improvement Exchanges Revenue Procedure 2000-37, issued on September 15, 2000, creates a safe harbor for reverse and improvement exchanges where an Exchange Accommodation Titleholder (EAT) enters into a parking arrangement and acquires title to either the relinquished or the replacement property. Strategically applied, these types of exchanges empower commercial investors the ability to enhance their investment alternatives. Seize the Moment: Immediately acquire a desirable replacement property prior to selling the relinquished property. Many commercial investors are using this strategy to acquire an excellent investment as soon as a good purchase is placed on the market. Particularly in markets where the inventory of properties is low or turnover is fast, this strategy enables the investor to acquire their next investment property as soon as a good purchase opportunity is available. Protect the Exchange: Eliminate the pressure-filled problems presented by the 45-day identification period. Thousands of commercial transactions are not closed each year because investors are unable to locate suitable investments within the 45-day identification period imposed by the tax code. Revenue Procedure 2000-37 empowers an investor to close on his ideal replacement property before selling the relinquished property, 48
thus eliminating the time crunch and potential loss of a good purchase opportunity. Create the Investment: Build from the ground up or improve an existing property to create an investment that meets the exact needs of the investor. Many investors have discovered they can build a brand-new investment property, all with tax deferred dollars, and meet the IRC requirements. Owner-users are using this strategy to build a new warehouse or office building that meets their exact requirements, rather than being limited only to properties available on the market. In fact, this exchange opportunity provides tremendous flexibility because a Certificate of Occupancy within the 180-day exchange period is not required to meet the requirements for full tax deferral. But a prudent investor will remove all obstacles to construction prior to closing the sale of the relinquished property, because the only funds that qualify for the exchange are those spent on the land and actual improvements made before taking title, which of course must be done within 180 days. More investors are combining a reverse exchange with an improvement exchange and creating a perfect opportunity to purchase the new property first and then begin making improvements to the property before the relinquished property is sold to a buyer. Benefits of the Improvement Exchange Improvement exchanges offer a taxpayer a wide array of benefits that often result in a better SCENARIO: Exchanger is selling a $1 million warehouse and wants to build a new and larger warehouse. The seller will pay $70,000 in closing costs on the sale and pay off a $200,000 loan. The new warehouse-both land and improvements, will be worth $3,000,000 at completion and will consist of $730,000 equity and $2,070,000 financing with a local lender. Only $930,000 (debt relief plus net equity) must be reinvested in like-kind real property within the 180- day exchange period. The Exchanger will complete the remainder of the improvements after the exchange is completed and he is back on title to the land and a partially completed building. investment than properties readily available on the open market. The ability to renovate, add capital improvements, or build from the ground up, while using tax deferred dollars, creates tremendous investment opportunities. Taxpayers must meet three basic requirements in order to defer all of their capital gain in the improvement exchange format: 1) Reinvest the entire net exchange equity on completed improvements or down payment by the 180th day. 2) Receive substantially the same property identified by the 45th day. Spring 2005 professional report 49
3) The replacement property must be of equal or greater value at the time of transfer to the taxpayer. The final value of the replacement property is the combination of the original purchase price plus the capital improvements made to the property. The taxpayer does not have to have a completed building transferred to qualify for tax deferral. For example, a taxpayer who is selling a $1 million relinquished property that is free and clear and who plans to have a $3 million replacement property constructed, need only to have at least $1 million of combined value in the partially completed building and land to qualify for full tax deferral. As long as the value of the land and improvements completed are at a level to defer the taxes, the exchange can be completed. However, it must be completed substantially as was initially planned. The Format In a typical improvement exchange, the taxpayer uses a Qualified Intermediary to sell his or her relinquished property. An affiliate of the Qualified Intermediary (QI), an Exchange Accommodation Titleholder (EAT), uses the proceeds from this sale to Purchase a new replacement property from a third-party seller. Make improvements to the property to increase the value until it is worth as much or more than the sale property. Transfer improved property to the taxpayer within 180 days after the day the relinquished property was transferred. Using the EAT and QI in this manner, allows the taxpayer to control the property and improvements built thereon. The EAT is treated as owning the property for federal income tax purposes; however, the taxpayer is able to reinvest the proceeds from the sale of the relinquished property in the land and improvements tax deferred. This creates greater tax deferral than the taxpayer would obtain if only the land had been replacement property. Tax-deferred exchanges remain a great tool for increasing owners ability to buy new and bigger buildings, increase depreciation deductions, expand choices of investments and locations, and improve overall return on investment. The latest and most creative strategies involve tenantin-common programs that increase the investor base, parking arrangements that permit the purchase of the new property first, and improvement exchanges that allow the owner to construct a new building to his specifications. Each scenario is unique and requires specific tax advice. 50