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What is a 1031 Exchange?
Section 1031 of the tax code provides one of the best strategies for the deferral of capital gains taxes which would ordinarily arise from the sale of real estate. Exchanging defers the recognition of the capital gains tax, leaving the property owner with substantially more proceeds to purchase a replacement property. The tax code states, "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment purposes if such property is exchanged solely for property of like-kind, which is to be held for other productive use in trade or business or for investment purposes." Real Estate Investors can accomplish virtually any investment objective with 1031 exchanges, including greater leverage, diversification, improved cash flow, geographic relocation, and/or property consolidation.
Frequently Asked Questions
What is a 1031 Exchange?
A 1031 Exchange is a transaction in which a taxpayer is allowed to sell one property and buy another without a tax consequence. This can be done through a simultaneous or delayed 1031 Exchange. The transaction is authorized by Section 1031 of the IRS Code. It is the best strategy for the deferral of capital gains tax that would ordinarily arise from the sale of real estate.
A successful exchange results in the taxpayer being able to utilize 100% of the proceeds from the sale of property to purchase a new property, thereby deferring capital gains taxes.
How does it work?
A 1031 Exchange is usually a three-way delayed exchange, referred to as a "Starker Exchange", in which an intermediary is used to facilitate the transaction. There are four basic steps:
- Seller arranges for sale of property and includes exchange language in contract.
- At closing, sales proceeds go to a Qualified Intermediary for a 1031 Exchange.
- Seller identifies potential exchange properties within 45 days of the closing.
- Seller completes 1031 Exchange within 180 days of closing.
In a 1031 transaction, these steps can also occur simultaneously. Preferable, before you sell your property, you need to consider what type of replacement property will work best for you, and whether or not you want to own a whole or partial interest in a property. Increasingly, investors are choosing to purchase a partial Tenants In Common interest for several reasons.
Advantages of Undivided Tenants in Common Interest Ownership
It is often difficult in the short 45-day time frame to locate a property that has the right purchase price, debt ratio, and closing schedule to meet the 1031 exchange requirements-and then arrange any financing that may be necessary. A Tenants in Common ownership interest has a number of advantages, such as
- Flexible size to match your needs
- Pre-arranged financing
- No management hassles
- Potential for increased after-tax cash flow
- Economies of sale
- Can be identified and closed in a timely manner
- Investment can often be diversified into more than one property
How will a Tenants In Common 1031 Exchange benefit me?
You may own management-intensive real estate. Although you are comfortable with real estate investments and have had good returns in the past, you do not like the daily headaches that can accompany real estate management. You are ready to give up the hassles of dealing with tenants, maintaining facilities, paying property taxes, etc. You would like to sell your property but are faced with onerous tax consequences on the sale. You'd rather enjoy the income from the property and let someone else manage it. With a TIC 1031 Exchange, you can do exactly that.
A TIC 1031 Exchange allows you to exchange your management-intensive property for an institutional-quality property with the potential to generate steady income, tax benefits and appreciation. With a TIC 1031 Exchange, you no longer have to feel burdened by your real estate. Through your management contract, a manager will be retained to manage the asset while you enjoy all the benefits of income property ownership-and freedom from management duties.
Your income from the replacement property may be higher than what you were receiving from the original property. You can earn substantial cash flow that may be up to 60% sheltered by the depreciation of your new basis in your TIC purchase.
No capital gains taxes may be due until the replacement property is eventually sold. If you shuffle off this mortal coil while owning a property, your heirs will receive a stepped up basis and the capital gains tax will be completely avoided.
How do I get started?
Discuss your specific needs with your registered representative, SID JAIN @ 408-836-3858 (direct) OR send email to sidjain@mymoneymall.com or sidjain@aol.com Sid Jain will be happy to answer your questions and provide you with the information you need to consider a 1031 Exchange.
Why do business with Sid Jain/MoneyMallUSA Corp.? What is their role?
Sid Jain is a TIC Broker in his capacity as a Registered Representative. Through Mr. Jain's relationships with companies that specialize in the 1031 Tenant in Common form of ownership of income producing real estate, the chosen company will also assist you in finding Replacement Property(ies), help in getting the loan, close the deal with professional property managers in place, distribute monthly income checks and finally at tax year end, mail you an Operating Statement on each property you invested in, with that company. From start to finish, all you have to do is to take that operating statement to your tax professional for your tax purposes. Your cost basis is your own. Usually, most companies like to sell the TIC Investor owned properties every 5 to 8 years. This also helps to UNLOCK any built up equity, thereby generating additional income on any new money(s).
The other advantage of doing business with us is that our existing TIC 1031 Investors are usually given first preference upon sale of their current portfolio TIC Properties with us, to exchange into a new property, generally reducing or eliminating the payment of current taxes on gains or having to find "like kind" replacement properties on their own. You can generally continue to repeat these tax favored investments into income producing real estate and enjoy a continuing income stream. Under current IRS Tax code, generally upon the investor's death, the heirs or your beneficiaries get stepped up cost basis. This can potentially save your heirs lot of money in income taxes. We do recommend that you should consult an Attorney or a Tax Professional for answers unique to your individual family, tax situation(s), etc.
Please call us at 408-836-3858 and ask for Sid Jain. Please be sure to leave us a message. We will usually get back to you in two business days or less. You can also email us at sidjain@mymoneymall.com. Thank you.
1031 Terminology
Like-Kind Property
Like-Kind refers to the type of property being exchanged. You can exchange any real estate investment for any other type of real estate investment - for example, vacant land can be exchanged for rental property. In most cases your personal residence is not Like-Kind investment property.
Exchanging Up
To accomplish a fully tax-deferred exchange, the rule of thumb is "exchange even or up in value; exchange even or up in equity and in debt."
Boot
To the extent that you do not exchange even or up in value and/or exchange even or up in equity and debt, you will have received non-qualifying property ("boot") in your exchange. If boot is received, tax is computed on the amount of gain on the sale or the amount of boot received - whichever is lower.
Typical Exchange Addendum Language for Sales Contracts
"Buyer hereby acknowledges that it is the intent of the Seller to effect an IRC Section 1031 tax deferred exchange which will not delay the closing or cause additional expenses to the Buyer. The Seller's rights under this agreement may be assigned to a Qualified Intermediary, named by Seller, for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and the Qualified Intermediary in a manner necessary to complete the Exchange"
1031 Do's & Don'ts
Do advanced planning for the exchange. Talk to your accountant, attorney, broker, financial planner, lender and Qualified Intermediary.
DO NOT miss your identification and exchange deadlines. Failure to identify within the 45-day identification period, or failure to acquire replacement property within the 180-day exchange period will disqualify the entire exchange. Reputable Intermediaries will not act on back-dated or late identifications.
DO keep in mind these three basic rules to qualify for complete tax deferral:
- Receive only "like-kind" replacement property.
- Use all proceeds from the relinquished property for purchasing the replacement property.
- Make sure the debt on the replacement property is equal to or greater than the debt on the relinquished property. (Exception: a reduction in debt can be offset with additional cash; however a reduction in equity cannot be offset by increasing cash.)
DO NOT try to do a 1031 exchange yourself using your CPA or attorney to hold title or funds. IRS regulation requires a Qualified Intermediary to property complete an exchange. Call us for the name of one that operates in your area.
DO attempt to sell before you purchase. Occasionally exchangers find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a "reverse" exchange (buying before selling) may be necessary. Exchangers should be aware that reverse exchanges are considered a more aggressive exchange variation because no clear IRS guidelines exist.
DO NOT dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchanger's legal relationship with the property may jeopardize the exchange.
IRS
The IRS provides an abundance of information on �½1031, like-kind exchanges and other tax issues. For your convenience, we have incorporated some of the most relevant information that the IRS provides on their website.
In addition, we have included several IRS reference documents available for download from the Internal Revenue Website.
For more detailed information on your personal tax issues, please visit www.irs.gov or speak to your tax advisor.
IRS Like-Kind Exchanges Tax Tips
Generally, if you exchange business or investment property solely for business or investment property of a like kind, no gain or loss is recognized under Internal Revenue Code Section �½1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.
Section �½1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.
IRS Frequently Asked Tax Questions And Answers
Can you sell rental property and reinvest it into rental property without paying capital gains tax?
Unless you exchange properties in a qualifying like-kind exchange, you may not defer the gain on the sale of your rental property by purchasing replacement property. For additional information on like-kind exchanges, refer to Publication 544, Sales and Other Dispositions of Assets.
I have heard that I can sell my rental property and use the proceeds to purchase rental property of greater value and the transaction is viewed just like an exchange in that the tax is deferred until the new property is sold. Is this true?
What you have heard about is a like-kind exchange. Like-kind exchanges are subject to several rules and restrictions listed in Publication 544, Sales and Other Dispositions of Assets.
We sold a rental property last year and used the �½1031 Tax Deferred Exchange law to defer the gains into another like-kind property. How do I handle this transaction on my tax return?
Report the exchange of like-kind property on Form 8824, Like-Kind Exchanges. The instructions for the form explain how to report the details of the exchange. Report the exchange even though no gain or loss is recognized.
If you have any taxable gain because you received money or unlike property, report it on Form 4797, Sales of Business Property, and Form 1040, SCHEDULE D, Capital Gains and Losses. Refer to Publication 544, Sales and Other Dispositions of Assets, which has a detailed section on like-kind exchanges.
What is a Like-Kind Property?
Internal Revenue Code, Section 1031 outlines the essentials for deferring tax gain on property sale to a "like kind" property.
Property held for productive use in a trade or business, such as income property, or
Property held for investment
Glossary
�½1031 Buyer Representation
Real Estate Brokerage Company with expertise in �½1031 Exchanges. Their main function is to represent the interests of the �½1031 buyer rather than to the property broker who has a fiduciary responsibility to the seller.
�½1031 Exchange
Internal Revenue Code, Section �½1031 states that neither gain nor loss is recognized if property held for investment or for productive use in a trade or business is exchanged for property held for investment, trade or business. There are several kinds of �½1031 exchange methods used today, including delayed exchanges, simultaneous exchanges, and reverse exchanges.
�½1031 Tax Deferred Exchange
An exchange where, pursuant to "An Agreement" the taxpayer transfers property held either for productive use in a trade, business or for investment and receives a new property to be held either for productive use in a trade, business or for investment.
1991 Revisions
Year when the IRS held a hearing to "clean up" the Tax Reform Act of 1984 and provide uniform terminologies. A main result of this revision was that the IRS eventually had a change of attitude toward Delayed Exchanges by accepting them instead of fighting them.
Accommodator
A qualified intermediary who agrees to assist the exchanger to affect a tax-deferred exchange. Also described as a facilitator or an intermediary, a qualified intermediary cannot be the taxpayer, a related party, or an agent of the taxpayer.
Adjusted Basis
The basis of a property adjusted for any capital improvements or depreciation. To calculate the adjusted basis, add the basis (the cost of the property), to the cost of any capital improvements made to the property during the taxpayer's ownership, and subtract the depreciation taken on the property during that specific time period. Once the adjusted basis is known, the gain or loss can be computed.
Appreciation
An increase in an asset's value.
Asset allocation
Dividing investments among different kinds of assets, such as stocks, bonds, real estate and cash, to balance the risks of investing. Asset allocation models vary based on an individual's specific financial goals and situation.
Basis
System of measuring investment in property for tax purposes.
Example: Original cost, plus improvements, minus depreciation taken.
Basis in the Replacement Property
In an exchange, the deferral of the tax on the gain is accomplished by requiring the taxpayer to carryover (substitute) the basis of the relinquished property to the replacement property with suitable adjustments in the event additional consideration is paid.
Bear market
An extended period of falling value of the overall market, accompanied by widespread pessimism.
Boot
In an exchange of real property, any consideration received other than real property is "boot." The amount of gain recognized is always limited to the gain realized or boot, whichever is the smaller amount. For a transaction to result in no recognized gain, the taxpayer must receive property with an equal or greater market value and debt than the property relinquished, and receive no boot. In exchanges, there are two types of boot: cash boot and mortgage boot. Cash boot is cash or anything else of value received. Mortgage boot is any liabilities assumed or taken subject to in the exchange.
Broker/dealer
An individual or firm that is in the business of buying and selling securities. Broker/dealers are registered with the Securities and Exchange Commission (SEC).
Bull market
An extended period of rising value of the overall market.
Buyer
Person who wants to acquire the exchanger's property. For a three- or four-party exchange, the buyer usually has cash.
Capital appreciation
Increased market value of an asset as measured by share price.
Capital Gain
Difference between the sales price of the Relinquished Property less selling expenses and the adjusted basis of the property.
Class "A" property
Most prestigious buildings competing for premier office users with rents above average for the area. Buildings have high quality standard finishes, state of the art systems, exceptional accessibility, and a definite market presence.
Concurrent Exchange
Also referred to as a simultaneous exchange when the Exchanger transfers out of the Relinquished Property and receives the Replacement Property at the same time.
Constructive Receipt
Control of the cash earnings without real physical possession by the Exchanger or their agent.
Closing
The transfer of title of real property in a real estate transaction.
Deferral
Tax on an exchange transaction is not paid at the time of transaction but at the time the replacement property is sold. Deferral is accomplished by substituting, or carrying over the basis of the taxpayer's relinquished property to the replacement property making any necessary adjustments for additional consideration paid.
Deferred Exchange
term currently used in place of "Non-Simultaneous Exchange" or "Starker Exchange." A type of exchange where the Exchanger utilizes the exchange period.
Delayed Exchange
Also known as non-simultaneous, deferred, and Starker. A delayed exchange is when the Replacement Property is received following the transfer of the Relinquished Property. All potential Replacement Properties must be identified within 45 days from the transfer of the Relinquished Property and the Exchanger must receive all Replacement Properties within 180 days or the due date of the Exchanger's tax return, whichever comes first.
Depreciation
Decline in value of an asset. Property depreciation occurs due to general wear and tear.
Depreciation Recapture
Exchanges of like-kind property ordinarily do not trigger any depreciation recapture (that is, deductions taken in excess of straight-line depreciation under Section 1250 IRC). When there is an exchange into a property of lesser value, or when the exchange consists partly of cash and property not of a like-kind, consideration must be given to the depreciation recapture provisions of Section 1250 and the higher capital gain tax rates for depreciation recapture.
Direct Deeding
Vested owner deeds directly to the final owner. Doesn't eliminate the duties of the Qualified Intermediary to acquire and transfer the relinquished property and acquire and transfer the Replacement Property.
Diversification
Similar to asset allocation, diversification is a strategy designed to reduce overall portfolio risk.
Due diligence
The practice of investigating a potential investment.
Exchange Equity
The "cash" and other "property" available at time of closing on the sale of the relinquished property.
Exchangor
Party wishing to defer tax on gain on the exchange of investment property.
Exchange Period
The replacement property should be received by the taxpayer within the "Exchange Period," which ends on the earlier of 180 days after the date which the taxpayer transferred the property relinquished, or the due date for the taxpayer's tax return for the taxable year when the transfer of the relinquished property occurs (such as April 15th). The exchange period is 180 days, due to the Taxpayer's ability to extend the date of payment.
Gain
The amount obtained for a property minus the property's adjusted basis, and transaction costs. No matter what the adjusted basis of a property is, there's no gain until the property is transferred. There are two types of gain "realized gain" and recognized gain." Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section �½1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like-kind property is received, no gain is recognized at the time of the exchange.
Growth Factor
Interest earned for the duration of the exchange that is payable at the end.
Identification Period
The replacement property must be identified within 45 days of the close of escrow/closing the relinquished property. If the 45th day happens to fall on a weekend or legal holiday, it is not to be extended.
Income property
Real estate that generates cash flow.
Intermediary
The party who facilitates a tax deferred exchange by acquiring and selling property in an exchange. The intermediary plays a role in almost all exchanges these days. He or she neither begins nor ends the transaction with any property. He or she buys and then resells the properties in return for a fee.
Leverage
The degree to which an investor or business is using borrowed money.
Liquidate
To convert assets into cash.
Like-Kind Property
Any valid property for any other valid property if the property(s) are held for productive use in trade, business or for investment purposes.
Liquidity
The ability of an asset to be converted into cash quickly.
Financial Industry Regulatory Authority (FINRA)
A self-regulatory securities industry organization responsible for the operation and regulation of the stock market and for conducting regulatory reviews of members' business activities.
Net lease
A property lease in which the tenant pays all expenses normally associated with ownership, such as utilities, maintenance, repairs, insurance, and taxes.
Net worth
Total assets minus total liabilities of an individual or company.
Non Recourse Loan
A loan whose terms include the lender agreeing that its sole remedy in the event of failure to repay will be to foreclose against the property securing the loan.
NNN Triple lease
A lease that requires the tenant to pay for property taxes, insurance and maintenance in addition to the rent (also referred to as Net Net Net Lease or Triple Net Lease).
Operating costs
The day-to-day expenses of running a business.
Ordinary income
Income other than capital gains.
Passive income
Income derived from business investments in which the individual is not actively involved, such as a real estate limited partnership.
Portfolio
All investments collectively owned by the same individual or organization.
Qualified Intermediary (QI)
The corporation who acts as the accommodator in the exchange. A qualified intermediary is identified as follows:
- Not a related party to the Exchanger, (e.g. agent, attorney, broker, etc.);
- Receives a fee;
- Acquires the relinquished property from the Exchanger; and
- Acquires the replacement property and transfers it to the Exchanger.
Realized Gain
Gain that is not necessarily taxed. In a successful exchange the gain is realized but not recognized and thus not taxed.
Recognized Gain
Amount of gain which is subject to tax when property is disposed of at a gain or profit in a taxable transfer.
Relinquished Property
Old property that is being sold by the Exchanger. (Formally called the Down leg property, currently called Phase I property).
Replacement Property
New property being acquired or the target property being brought by Exchanger. (Formally called up leg property, currently called Phase II property).
Return
The profit made on an investment, expressed annually as a percentage of the total amount invested.
Registered Representative
An individual who sells securities and has the legal power of an agent, having passed the Series 7 or Series 22 and Series 63 examinations. Usually works for a brokerage who is a member of SEC, NYSE, and FINRA.
Risk
The possibility of loss of capital on an investment.
Safe Harbor
Term identifying the requirements to protect the Exchanger's money and the "Qualified Intermediary."
Securities and Exchange Commission (SEC)
The primary federal regulatory agency for the securities industry, whose responsibility is to promote full disclosure and to protect investors against fraudulent and manipulative practices in the securities markets.
Securities Investor Protection Corporation (SIPC)
Member of SIPC, which protects securities customers of its members up to $500,000 (including $100,000 for claims of cash).Explanatory brochure available upon request or at www.sipc.org
Seller
The person who owns the property that the taxpayer wants to acquire in the exchange in a three or four party exchange.
Sequential Deeding
Property that's deeded to the Intermediary whereby the Intermediary deeds to the final owner.
Simultaneous/Concurrent
Exchange without any time between the sale and purchase.
Simultaneous Exchange
Also referred to as a concurrent exchange when the Exchanger transfers out of the Relinquished Property and receives the Replacement Property at the same time.
Starker Exchange
A term used to describe delayed exchanges. "Starker vs. Commissioner" established the delayed exchange concept. The term "starker exchange" is used as another way of referring to delayed, deferred or any other non-simultaneous exchange.
Tax-advantaged
Having other tax benefits that typically result in tax savings.
Taxpayer
Also known as the exchanger. A taxpayer has property and would like to exchange it for new property. While all parties in an exchange are theoretically taxpayers, this term applies to the party who expects to receive tax deferred treatment under Section �½1031.
Tax Reform Act of 1984
In the Tax Reform Act of 1984, Congress addressed the IRS's continued displeasure with the Starker decision by amending Section �½1031 to allow Delayed Exchanges; but only if all of the exchange property is identified and acquired within specific deadlines (see Exchange Period). And most important in the Conference Report accompanying the 1984 Act, Congress specifically reaffirmed that a "sale" followed by reinvestment in like-kind property doesn't qualify for tax deferral under Section �½1031. So to qualify for tax deferral, it is still essential to cautiously structure an exchange to avoid actual or constructive "receipt" of proceeds of sale and to prevent characterization of the transaction as a taxable sale and reinvestment.
Tax shelter
A technique that allows an investment to be legally exempt from federal, state, and local taxes to varying degrees.
Transaction Costs
Any cash paid by way of commission or other expense in an exchange. Transaction costs are deducted in computing the consideration received.
Transfer Tax
A tax assessed by a city, county or state on the transfer of property that may be based on equity or value. The use of direct deeding in an exchange avoids additional transfer tax.
Undervalued
Perceived to be below its value.
TIC Talk, or, Another Side of the 1031 Story
5/1/2003
By: Richard Chess,* Regional Vice President of Eastern Markets - Triple Net Properties, LLC
The eighty plus year evolution of like-kind exchanges of real estate under the federal tax code has been covered in a prior issue of this publication by Louis J. Rogers, a partner at Hirschler Fleischer. Deferred exchanges became accepted by litigation in the 1970s and were codified in the late 1980s (45 days to identify, 180 days to close). Use of a tenant-in-common ("TIC") structure to accomplish like-kind exchanges became popular on the West Coast in the mid-1990s. Work by Rogers, the "Dean of 1031s," and others resulted in official acceptance last year of the TIC structure by the IRS as reflected in the fifteen-point "guidelines" of Rev. Proc. 2002-22.
Raising equity in a TIC format has become a multi-billion dollar a year business. What are the business and economic forces driving what has been exponential growth over the past three years of TIC like-kind exchanges under Section 1031 of the Internal Revenue Code? How may this "sized to fit" approach to like-kind exchanges impact your legal practice in Virginia? Where are some of the potential "land mines" (e.g., unregulated Qualified Intermediaries) that could derail the TIC business?
A. BUSINESS AND ECONOMIC FORCES
1. Crash of the Stock Market
For more than five years, the rising tide of Wall Street raised the value of most stock portfolios. Since early 2001, when the "crash and burn" of major technology and telecommunications companies was followed by a general weakening of the U.S. economy, nearly all stock portfolios have been dramatically reduced in value. Investment grade real estate is one of the few investment classes benefiting from the down turn in the stock market (note the strong growth in the price of publicly traded real estate investment trusts ("REITs"). Traditional real estate syndication, thought by many to have died with the 1986 Tax Reform Act, is again a HUGE business. Wells, an Atlanta based real estate firm, raised over $1 billion in 2002 for their private real estate investment vehicles.
2. Real Estate Markets Weaken
The accelerate flow of investment capital into real estate is pushing up the price of institutional quality real estate. This escalation of price is occurring at the same time when the business fundamentals for commercial real estate are weakening. William W. Reynolds, SVP�½CB Richard Ellis, notes that, "Office vacancy in �½A grade' properties has been in the double digit range for the last eighteen months. Vacancy is substantially higher in �½B' and �½C' grade office markets." Retail economics have been rocked by high profile bankruptcies (e.g., Kmart). Only two of forty apartment acquisition officers, meeting mid-April in New Orleans at a conference of the National Multi-Housing Council, anticipate growing the portfolio of their firms due to perceived overpriced properties coupled with a flat market due to a lack of job growth in their target markets.
3. Fear and Aging
Recognition by some investors that the "gravy years" of the economy are behind us has resulted in a huge increase in the number of "sub-institutional" size properties (less than $10 million in value) coming to the market. These investors, in the words of one in Alexandria, are determined NOT to be the "last train out of town." They also don't want to lose 20 to 30 percent of their gain on sale to taxes, so a like-kind exchange is attractive. On the other hand, many of these investors are of the "baby boom" generation, where "time to live" has become more important than "portfolio to grow." They don't want to continue to manage a property.
4. Lack of Net Lease Alternatives
For the investor wanting to delay recognition of capital gains and hence a current payment of a capital gains tax, and also wanting to move away from property management, a like-kind into a net leased property (tenant pays for all building related expenses) has been an attractive alternative. Demand for this type property has exceeded availability for several years. Yields have dropped into the low single digit. The bankruptcy of several major retail and pharmacy firms has resulted in some lenders pulling away from this product. The size of the required investment seldom matches exactly the equity available from the investor.
5. TIC of Real Estate in a Syndicated Format
A Google search on the internet of "1031" and "like-kind exchange" results in over 1200 listings of firms offering services. The dominate groups are real estate brokers (for direct sale of real estate), qualified intermediaries (required by the IRS to hold the proceeds of the sale), and registered representatives (who sell TIC investments in a security format). There are fifteen real estate firms listed which offer access, at least on a regional basis, to syndicated TIC investments of commercial real estate. Office building TIC sponsors (e.g., Triple Net Properties) offer access to institutional quality multi-tenant properties in a "sized to fit" investment unit. Shopping center sponsors (e.g., Pasco) offer access to retail properties typically with an anchor tenant on a long-term lease. Apartment sponsors (e.g., RK Properties) divide their properties into individual building tracts so that the resulting investment unit is sufficiently small to accommodate the investor with less than $200,000 equity. A registered representative may have access, at any given time, to 10-20 properties of different types and in multiple markets and at a range of investment unit sizes. While there are numerous risks to a TIC investment (see below), TIC sales are rapidly increasing due to an increased demand for real estate investments that fit the size, location, product type, and no management needs of an aging population. Add to that mix a national sales force exceeding 100,000 registered representatives in various investment firms �½ registered representatives who are searching for a product to replace the income they once received for selling stocks, bonds, and mutual funds �½ and the potential for frenzy in the marketplace becomes apparent.
B. IMPACT ON LEGAL PROFESSION
1. Basic Rules
To accomplish a like-kind exchange, your clients must establish prior to their sale their intention to do a like-kind exchange (typically a paragraph added to the purchase and sale agreement) and to have entered into a written agreement with a qualified intermediary who will hold the proceeds of the sale. Once the sale is completed (of the "Relinquished Property"), your client has forty-five (45) days to identify in writing with specificity (use the address of the property) to the qualified intermediary what properties your client intends to purchase. Generally your client will either identify up to three (3) properties of any value OR they will identify an unlimited number of properties as long as the total value of all the identified properties (or that portion that the client proposes to own) does not exceed twice the sale price (less closing expenses) of the Relinquished Property. Your client must close on properties from the list received by the qualified intermediary within one hundred eighty (180) days of the sale of the Relinquished Property. In order to fully delay recognition of gain on the original sale, the acquired properties in total must equal or exceed the net proceeds, total debt and total cash proceeds received from the sale of the Relinquished Property. Any portion not covered ("boot") is taxed by the federal government 15% on gain due to an increase in value and 25% on gain due to depreciation. Most states (for instance, Virginia) apply a tax on the full amount of the gain.
2. Attorney Disqualified as Qualified Intermediary
The IRS Final Rules and Regulations on Delayed Exchanges (effective June 10, 1991) define what "disqualified person" can NOT serve your client as a qualified intermediary. Specifically disqualified is the investor and broadly defined "related parties." A party is disqualified to serve as a qualified intermediary if, within the two years preceding the sale of the Relinquished Property, they served the investor as their employee, ATTORNEY, real estate broker or agent, investment banker or broker, or accountant. There is an exception to the disqualification if the party only provided routine financial, trust, title insurance, or escrow services, or services solely with respect to the exchange of property.
3. Attorney Role in Selection of Qualified Intermediary
There are five national qualified intermediary firms. Four are associated with title insurance firms (Fidelity, First American, LandAmerica, Stewart Title) and one is exclusively involved in like-kind exchanges (Starker). Several national banks (e.g., Wachovia) have made strong moves to grow in this business. Since there is NO regulation of qualified intermediaries, it may well be best to guide your client to working with a national firm with deep pockets and substantial experience.
4. Attorney Role in Selection of Real Estate
Unless the client is specifically paying the attorney to review the client's real estate investments, the attorney is best served referring the client out to more than one real estate broker and more than one registered representative, and documenting to the client that the attorney is NOT providing assistance to the client in real estate selection. The Virginia State Bar has already received an ethics complaint against an attorney who, the client claims, failed to properly assist the client in the attempted acquisition of replacement property for a like-kind exchange.
5. Limited Transferability of a TIC Interest
While a TIC investor has the right, in a program reflecting the guideline of Rev. Proc. 2002-22, to sell their investment unit, the lender on the property may restrict free transferability. There is no ready secondary market for TIC investment units, so even with lender approval, there may be no buyers or no buyers without a significant discount of price.
6. Limits on Access to TIC Investing
Sponsors of TIC programs require, with few exceptions, that investors be accredited�½have a net worth in excess of one million dollars or have an annual income for the last two years of $200,000 (or $300,000 including the income of a spouse).
The size of the minimum investment is driven by:
a) the fully loaded cost of the property being acquired;
b) the amount of debt the lender will place against the property;
c) the number of TIC units allowed by the lender; and,
d) in some cases, the number of special purpose entities allowed by the lender.
A loan on a TIC property can be securitized and sold on Wall Street IF the rating agencies are comfortable with the TIC structure (in addition to all their other underwriting criteria). Because of rating agency issues, or if the loan must be carried on the books of the lender, most lenders through third quarter of 2002 limited the number of TIC investors to ten. Increased competition for the loans and some enlightenment of the rating agencies is resulting in some lenders allowing up to the full 35 TIC positions allowed under Rev. Proc. 2002-22.
The strongest demand for TIC investments has been in the $200,000 to $400,000 range. Product sponsors are finding that programs offering investment units in this range, assuming that the underlying real estate and market are attractive, are selling out in less than ten business days. Your client needs to juggle both the forty-five day identification period imposed by the IRS and an access to product timetable (whether TICs, net lease properties, or other direct ownership of assets) which at times can be daunting.
C. POTENTIAL LAND MINES
1. Qualified Intermediaries
The fees for a standard deferred like-kind exchange have dropped for most companies to the point that, without significant volume (over one thousand exchanges a year), it has become difficult to justify being in the qualified intermediary business except as a "lost leader" to acquire other business. A few investors have experienced single person qualified intermediaries disappear with the proceeds from the sale of the Relinquished Property. Some smaller qualified intermediaries have gone to becoming a registered representative and selling TIC product directly to their customers. A bill has been introduced in Congress which proposes to eliminate the forty-five day identification period and the need for a qualified intermediary.
2. Delaware Statutory Trust
A Delaware Statutory Trust ("DST"), if designed to meet the requirements of Rev. Proc. 2002-22, could solve the rating agency issue raised above. For the purpose of the loan, there would be one entity, and the loan would likely be underwritten as any other loan for securitization purposes. The Trust would need to be a pass through entity that did not exist for tax purposes. The IRS has given assurance in direct meetings with counsel for sponsors that a DST, properly structured, could be an acceptable vehicle to accomplish a like-kind exchange. Unfortunately, in a public meeting in February 2002, a regional representative of the IRS stated that use of a DST would result in an audit and a likely disallowance of the tax deferral. A Rev. Proc. regarding the DST issue is anticipated from the IRS by the end of first quarter 2004. In the interim, demand a strong detailed legal opinion from the counsel for the sponsor.
3. TIC Property Issues
The pool of institutional quality real estate which will work for a TIC transaction is limited. Above a certain size, the fully loaded purchase price less the debt the investing public will accept (generally around 60%), results in an investment unit size too large for most investors. Smaller properties may solve the investment unit size challenge, but generally do not have high quality tenants with long-term leases. If a property is encumbered with debt which has previously been securitized, it is unlikely that the current holder of the debt will approve transfer to a TIC group of investors.
Only a handful of the TIC sponsors have a track record which includes the SALE of properties. In commercial real estate, until a sponsor demonstrates an ability to repeatedly take the properties full cycle (buy, lease, manage, and then sell), it is impossible to determine their ability to replicate success with the subject offering.
The TIC sponsor, under Rev. Proc. 2002-22, may NOT participate in the back end increase in value of a property as they would if they were a sponsor of a limited partnership. Are the fees structured in a TIC program where the TIC sponsor earns its fees primarily when the TIC investors make the money (e.g., a real estate brokerage fee on sale can align the interests; a flat asset management fee, on the other hand, is paid no matter how well the property is operated)?
D. SUMMARY
Your clients are looking for an alternative to paying capital gains taxes on the sale of their real estate held for investment. Investing in a TIC ownership of real estate may give them the "sized to fit" investment unit they need and provide that investment within the time frames set by the IRS to identify properties. Progress on the DST format will further fuel the growth of this means of solving the like-kind exchange challenge.
*Richard B. Chess is Of Counsel at FutureLaw, L.L.C. in Richmond, Virginia and Director of the 1031 Transactions at Triple Net Properties, a Santa Ana, California based real estate firm. He serves as an Area Representative and a Subcommitte Member for the Commercial Real Estate Subcommittee, Land Use and Environmental Subcommittee, and Programs Subcommittee of the Real Property Section of the Virginia State Bar. |