Development - October 2008

Long-term Exchange Strategy

Say you’ve been holding real estate for use in your trade or business, or for investment purposes, that no longer suits your needs or objectives and you’d like to exchange your property for one that is better suited, while deferring taxes on the gain on the property you now own. If you’d like to understand how to continue to exchange properties and build wealth in the process, you should carefully consider the property exchange provisions of Internal Revenue Code Section 1031.

In addition to the fact that it is a tool for deferring partial or total tax on the gain, a 1031 exchange allows you to:

• swap your property for one more suited to your current business needs

• relocate an investment to a more suitable location (perhaps you have moved)

• convert from non-cash flow property (land) to one that provides an income stream — retail strip center or multifamily

• eliminate management headaches by exchanging a management intensive property such as a multi-tenant or multifamily to one that requires little or no management — like a single tenant office with a triple net lease

Many investors use the 1031 exchange to accomplish one or several of the above investment goals and, in each instance, defer tax. An often overlooked and most advantageous aspect of the 1031 exchange is to use the wealth building capacity of making many exchanges over time.  There is no limitation to the number of property exchanges a taxpayer can engage in, and the compounding effects of several exchanges over a 10- to 20-year cycle may be used to build significant wealth.

Compounding occurs when the investor reinvests all of the sales proceeds, including the tax savings, into the new property and continues to do so each time a property is exchanged for another. With each transfer, the investor is able to use leverage to acquire a property of a higher value. Key is for the investor to acquire under-managed, under-performing properties and add value through proper management and increased occupancy, which translates into more income. The reinvestment of the tax deferral on each exchange and the continued efforts toward improving the performance of each asset acquired to maximize sales value adds up to significant gain each time a property is exchanged. There are investors who have done five exchanges over 10 to 15-year time frames that have turned the dollars that they would have otherwise paid in taxes into real estate worth several million dollars.

If you decide to use the 1031 exchange to meet an immediate need or objective, or have selected it as one of your wealth building strategies and want to know more about it, you should seek guidance and analysis. Consult with a CPA, a commercial Realtor, your attorney and a Qualified Intermediary to become familiar with the stringent requirements, the process and the parties involved. These exchanges require advance tax planning and attention to structuring formalities. The number and types of properties involved are defined in the tax code and include property used in trade or business or for investment purposes, as well as qualified depreciable business property.

There are two phases to the exchange process, which don’t necessarily have to occur simultaneously.

If the investor sells the old property to another party to buy replacement property, he must acquire:

• up to three replacement properties without regard to value;

• any number of properties whose total value cannot exceed twice the value of the relinquished property; or

• any number of properties whose aggregate fair market value is equal to at least 95 percent of the identified properties.

The maximum  identification period is 45 days, within which to locate and identify the possible replacement property or properties. The maximum acquisition period is 180 days to acquire all replacement properties.

The taxpayer is not allowed to have actual or constructive receipt of any funds related to the properties during the process. A Qualified Intermediary, which must be an independent party, is necessary to facilitate the tax-deferred exchanges. The QI guides the investor through the successful exchange, works closely with all parties related to the exchange, prepares documentation, holds sales proceeds, acquires replacement property and delivers funds to the closing agent.

Should you want to pursue one or multiple 1031 exchanges, there are many online sites that have FAQs and information on the 1031 exchange and qualified intermediaries. Remember that your CPA and local commercial Realtor are the resources to provide guidance to translate the complex details into a clear, client-specific solution for your wealth building strategy.

Flo Guidry Meadows is a CPA with 12 years of experience in commercial real estate, currently working as a Realtor with Coldwell Banker Pelican Real Estate.