The Good, the Bad, and the 1031 Exchange [RMA Journal, The]

**Deferring capital gains taxes on property sales can have unforeseen consequences.

Relationship banking has never been more in vogue than in the aftermath of the financial crisis. Despite the view that banking is a commodity service with few differences among competitors, financial institutions that focus on long-term relationships and provide value to their customers will be more likely to succeed in the future.

The 1031 exchange concept-by which a property owner disposes of one property and acquires another without having to pay capital gains on the transaction-is, by its very design, relationship-oriented because actions taken in the present will impact the future investment return for the client.

The concept of tax-free exchanges under U.S. tax law has its origins in the Revenue Act of 1921.1 This article identifies when a transaction may qualify as a 1031 exchange, introduces the economics of the exchange decision, and discusses the unintended consequences of this tax law.

1031 Exchanges

The musician Frank Zappa reportedly said that the United States is a nation of laws, badly written and randomly enforced. While this statement may or may not be accurate, it contains at least a grain of truth in that seemingly well-intended actions sometimes have perverse consequences.

Take, for example, the like-kind exchange under Internal Revenue Code (IRC) section 1031, which provides an exception to the payment of capital gains taxes on the sale of property. These like-kind exchanges, or 1031 exchanges as they are often called, have the stated aim of deferring the capital gains taxes paid in qualifying situations when business or investment property is sold.2

In order to qualify for the 1031 exchange, the property sold and the property acquired must be classified for either a business or investment purpose. This is typically an easy hurdle to clear. Additionally, the property must previously have been held for a productive business or investment use, and it is up to the taxpayer to prove that the property being sold was not owned for only a short period of time. Consequently, "flipped" properties do not qualify for 1031 exchanges, although there are no official definitions for what qualifies as the required term of ownership.

One rule of thumb is that the property should be held for at least two years. Two other requirements are that the property purchased must be owned in the same name as the property sold and that both properties must be located either inside the United States or outside of it. That is, if one property is located within the United States and the other is not, the transaction fails to meet the definition of a 1031 exchange.3

Someone unfamiliar with like-kind exchanges might think the term refers to something as rigid and specific as selling (relinquishing) one apartment building and buying (replacing it with) another apartment building, but this is not the intention of the like-kind requirement. As long as each property involved in the exchange is classified generally as either for a business or an investment purpose, it is not a requirement that the specified properties match in type. It is our contention that this simple, potentially value-enhancing transaction was yet another piece of coal in the financial meltdown furnace. Ultimately, what determines the value of a 1031 exchange is not the applicability of a particular property to arbitrary, governmental requirements, but rather the impact the deal has on the investor's (i.e., the customer's) long-run returns.

The Different Types of Exchanges

The simplest form of 1031 exchange applies to a simultaneous exchange of one qualified property for another. In this exchange scenario, there is no time interval between the closings of the relinquished and replacement properties.

A second form of 1031 exchange is the delayed or deferred exchange. As the name implies, the delayed exchange applies to transactions not consummated on the same day. Deferred exchanges were first introduced in the late 1970s when a taxpayer named Starker challenged the requirement that exchanges had to be simultaneous. The IRS has strict rules regarding when the delayed exchange must be completed in order to gain the tax exemption. Table 1 illustrates the required timeline for a qualified deferred 1031 exchange.

As Table1 shows, once the relinquished property is sold, the investor has five days in which to identify a qualified intermediary (QI), whose job it is to facilitate the transaction. Subsequently, there is a 45-day inspection period in which the investor can select up to three replacement properties for possible purchase.

Rules exist that allow for more than three properties, but most investors keep their choices limited, given the time pressures associated with closing the deal. Once the selection period has expired, the investor has 180 days in which to close the transaction. If the exchange of properties occurs within the mandated time limits, the investor does not have to pay taxes on the capital gains associated with the sale of the initial property.

A deferred exchange is relatively common and typically requires the investor selling the property to partner with a QI, defined as a person or entity that is neither the taxpayer nor an attorney, accountant, realtor, or other related party. The QI must enter into a written exchange agreement with the taxpayer desiring to facilitate the exchange.

The QI will maintain the necessary paperwork used to validate the acceptability of the transactions and also will act as an agent for the taxpayer. The QI also can add value for an investor in the form of estate planning.

Typically, a QI is a financial institution that acquires the relinquished property from the taxpayer (seller), transfers the property to the buyer, and then acquires and transfers the replacement property to the taxpayer. The QI charges fees for this service and may also obtain interest on idle funds held while the 1031 clock ticks.

Another form of exchange is the reverse exchange. In this situation, the replacement property is purchased and closed before the relinquished property is sold. Typically, the QI will take title to the replacement property until the relinquished property is sold. Following the sale, the QI will transfer the title of the replacement property back to the investor. The same timeline is in effect for reverse exchanges. If an investor fails to complete the reverse exchange within the mandated time limits, he or she will be subject to capital gains tax.

A final form of 1031 exchange is the improvement exchange. Under this scenario, the investor acquires a property and arranges for improvements before it is received as the replacement. The improvements can be construction of a building on an unimproved lot or simply improvements made to an existing structure. The improvements must occur prior to the conclusion of the 1031 exchange so that the value of the replacement property reflects the improvements at the completion of the exchange.

Exchange Economics

So how does an investor determine if a deferred tax exchange is beneficial? While most investors are attempting to reduce their taxes, tax avoidance is not the only consideration. Once a 1031 exchange is completed, the gain that is not reportable on the disposition of the relinquished property becomes a basis adjustment in the replacement property. The basis on a property acquired via a 1031 exchange is known as the substitute basis.

Because the goal of the 1031 exchange is to defer all capital gains taxes associated with the sale of the first property, let's review what happens in this scenario.

Assume a client approaches your bank desiring a 1031 exchange for a property with an adjusted basis (after sales costs) of $1.5 million that sold for $2 million, resulting in a capital gain of $500,000. Under a 1031 exchange, the basis of the acquired property is decreased by the amount of the gain. This means that, based on a 39-year cost recovery period, the annual depreciation expense applied to the property falls by $12,821 ($500,000 ) 39). For an investor in a 28% tax bracket, this represents an annual cash cost of $3,590 ($12,821 x 0.28).

Once the replacement property is sold, the deferred gain of $500,000 will be recognized. Because the exchange results in less depreciation each year, the basis of the property is smaller than it would have been had the 1031 exchange not occurred. For example, assuming a 10-year holding period, depreciation is diminished by a total of $128,210. This offsets the difference in capital gains:

Deferred gain from exchange$500,000

Less additional depreciation without exchange128,210

Net amount of capital gain $371,790

x Capital gains tax (20%)$74,358

Based on a capital gains tax rate of 20%, at the time of the exchange the investor saved a $100,000 tax payment, but this leads to lower depreciation and therefore a cash sacrifice of $3,590 in each year of the holding period, plus $74,358 in deferred taxes that must be paid when the replacement property is sold. In essence, this investor is borrowing $100,000 and repaying $3,590 per year for 10 years and a lump-sum payment of $74,358 in the tenth year, which translates into a borrowing rate of only 1.16% APR. This rate is attractive in most economic environments. Consequently, in this case, the 1031 exchange is most likely beneficial.

Exchanges at High Noon

The goal of a tax-deferred exchange typically is tax minimization. Nonetheless, the goal of deferring all of the capital gains taxes is achieved only when the following conditions are met:

* All cash from the sale is used to purchase the replacement property.

* The price of the replacement property is at least as much as the relinquished property.

* The investor obtains the same financing on the replacement property that was held on the relinquished property.

* Both properties meet the like-kind definitions and time frames.

Taxes will be assessed when these conditions are not met and if the equity is not "balanced" between the properties used in the exchange. Differences in the property values usually require the equities to be balanced with what is known as boot-an old English term meaning "an addition." Boot can take the form of money, debt relief, or the fair market value of "other property" received by the taxpayer to equalize the equity of properties in an exchange. Because it can take several forms, boot does not qualify as like-kind property and is thus subject to taxation.

For example, assume Investor A is selling office property with a market value of $2 million and the property is encumbered by $1.5 million of outstanding debt. Thus, Investor A has $500,000 of equity in the property. Assume that Investor B is selling retail property with a current market value of $1.9 million and the same level of indebtedness.

Table 2 reveals that Investor B must provide some additional equity to consummate the exchange. There are numerous alternatives available to both parties. Investor A might take $100,000 in cash out of the office property and replace it with debt to equilibrate the financing of the two properties. Investor B could add $100,000 in cash or some other form of security to balance the equities, or Investor B could pay down the debt on the retail property by $100,000. Ultimately, the two parties could undertake any combination of these actions to balance the equities being transferred.

Even if Investors A and B come to an agreement on a method to balance the equity of the properties being transferred, taxes will still apply because any of the alternatives represents boot. The taxpayer receiving boot is subject to taxation. Based on the example in Table 2, Investor A is subject to tax on the $100,000 received from Investor B. Consequently, to avoid capital gains taxes on boot, investors should never purchase a property that is selling for a price less than that of the relinquished property.

The Good: A Fistful of Dollars

From a taxation standpoint, the benefits of 1031 exchange can be substantial. For one thing, the deferment of the capital gains tax can greatly improve an investor's internal rate of return. Additionally, investors can employ a 1031 exchange to acquire properties that are appreciating faster than those relinquished, or consolidate assets by exchanging many properties for one that is equal in value to that of the combined properties.

IRS regulations allow for up to three properties to be selected irrespective of the aggregate fair market value, but a greater number of properties can be employed as replacements in a 1031 exchange, as long as at least one of two provisions is met. The first provision is that the aggregate fair market value of the replacement properties cannot exceed 200% of the aggregate fair market value of all exchanged properties as of the initial transfer date. This 200% rule allows an investor to diversify, or consolidate, in an effort to enhance the risk and return characteristics of the portfolio of properties. The second provision is the 95% rule, which allows for the selection of any number of properties, as long as at least 95% of the aggregate fair market value of the properties identified is eventually selected. Given the advantages, the decision to undertake a 1031 exchange seems simple, but these transactions do present some problems.

The Bad: Unintended Consequences (For a Few Dollars More)

The 1031 exchange was very popular during the past decade. For many investors, the idea of saving on capital gains today seemed to outweigh any losses associated with depreciation and higher capital gains tomorrow. In the rock-paper-scissors world of real estate investor decision analysis, tax savings today would appear dominant. What should become apparent from this discussion of tax-deferred exchanges is that the speed, size, and leverage of the transaction are all crucial elements in its success.

If boot taxation is avoided by continuously purchasing properties with higher and higher market value relative to what is being replaced, and if the general requirement of maintaining at least the current level of property indebtedness is satisfied, the 1031 exchange is a good fit with the property bubble mentality of the years preceding the recent financial crisis. Furthermore, when coupled with lenders justifying loan-to-value and debt coverage ratios by requiring additional equity investment, the 1031 exchanges at least partially maintained inflated property values.

Finally, if we add the ticking clock of the 1031 exchange timeline, market psychology comes to the forefront of the decision process. As a deal's deadline approaches, it is usually the case that the investor has spent a considerable amount of time and resources in the attempt to defer taxes. Rusbult's investment model states that the equity calculation of any relationship should include not only the costs and benefits of the current interactions and viable alternatives, but also previous investments in the relationship, so that the commitment to the relationship considers the past, present, and future.4 Because the 1031 exchange process entails an investor receiving and relinquishing at least two properties, and because many investors roll the capital gains over on more than one occasion, the consideration of banking customer relationships is relevant to the 1031 exchange decision.

In an era of cheap money, inflated and unsustainable property values, and inexperienced investors, the 1031 exchange was ripe to be overused. In this context, a myopic investor is more concerned with saving on the capital gains tax than on undertaking the due diligence that likely would occur in the absence of government-imposed rules and artificial time constraints. It is better to purchase the right investment at the right price than to make a hasty decision to save on the capital gains tax today.

Minimizing tax obligations is certainly a worthwhile endeavor, but it should not be the only goal. Financial institutions that market themselves on the basis of "relationship" should never lose sight of the fact that partnering with customers via 1031 exchanges has potential benefits for all parties. Nonetheless, this is true only when the properties are being financed and purchased at reasonable, economically justifiable values.

An investor who enters into a 1031 exchange hastily will likely drop a QI if dissatisfied with the investment's eventual return. In the final analysis, bankers are cautioned to work in partnership with their clients in an effort to find the right properties to finance via the 1031 exchange. If the bank can approve the loan only on the basis of a high equity position, the easy loan decision today may beget an unsatisfied client tomorrow when it is eventually discovered that the property was purchased at too high a price. Understanding the nuances of the process helps everyone navigate the good and the bad of the 1031 exchange.

What determines the value of a 1031 exchange is the impact the deal has on the customer's long-run returns.

Notes

1. Real Estate Investment Decision Making, by A.J. Jaffe and C.F. Sirmans, Prentice Hall, 1982.

2. "Like-Kind Exchanges Under IRC Code Section 1031," available at www.irs.gov/newsroom/article/0,,id=179801,00.html, accessed March 10, 2011.

3. Real Estate Finance and Investments, 14th ed., by W.B. Brueggman and J. Fisher, McGraw-Hill, 2010.

4. The Psychology of Marketing: Cross-Cultural Perspectives, by G. Raab, G.J. Goddard, R.A. Ajami, and A. Unger, Gower, 2010.

G. Jason Goddard is vice president at Wachovia Bank, a Wells Fargo Company, in Winston-Salem, North Carolina. He is adjunct faculty member at Wake Forest University, University of North Carolina-Greensboro, and the University of Applied Sciences in Ludwigshafen, Germany. He also teaches at the RMA-ECU Commercial Real Estate Lending School in Greenville, North Carolina. Bill Marcum is Citibank Faculty Fellow and associate professor of finance at Wake Forest University. The authors are completing a book (to be published by Springer) that analyzes investment real estate in the aftermath of the recent market decline. They can be reached at [email protected] and [email protected].

G. Jason Goddddard is vice president at Wachovia Bank, a Wells Fargo Company, Winston-Salem, North Carolina, and adjunct faculty member at Wake Forest University, UNC-Greensboro, and the University of Applied Sciences in Ludwigshafen, Germany.

(His article can be found on page 44)

Bill Marcum is Citibank Faculty Fellow and associate professor of finance, Wake Forest University, Winston-Salem, North Carolina.

(His article can be found on page 44)