Most commercial real estate owners and brokers know about potential 1031 exchange tax savings, but many are unaware of all the available innovative solutions related to 1031.
Section 1031 of the Revenue Code allows sellers of property to defer capital gain and recapture taxes if they “exchange” into a new property. Exchanges must be done through a specialized escrow agent called a “qualified intermediary” and within specified times. Exchangers may get tax savings plus the benefit of returns from capital previously lost to taxation. This can be very attractive on a simple sale, but skilled professionals know of other, less apparent, strategies available through the Section 1031 wrapper:
Owners held back from selling an overleveraged property may find tax relief through using zero coupon securities within a 1031 exchange. Buyers, sellers (and brokers) needing an exchange to make the transaction work may find the solution in specialty investment securities tailored to fit their needs. Perhaps there is difficulty making the debt side or equity side match. Sellers needing certainty of closing on their exchange replacement property may find 1031 investment securities attractive. Other sellers are reluctant to commit all their proceeds to one property; they are wary of concentrating risk. The use of a properly licensed securities and real estate professional is required, but a brief overview can help in strategic planning.
Upside Down Property
Over leveraged, or upside down, property often needs to be liquidated. Perhaps the profit has already been taken through a cash-out refinance in the past and a sale will create tax on the past refi proceeds. The owner is stuck with an unwanted property, the broker loses a sale and the owner loses the opportunity to buy a new property. The solution may lie in the purchase of a specialty 1031 security. These zero coupon products generally provide high loan to value, non-recourse debt to be utilized in a 1031 exchange. In many cases the tax benefits are sufficient to enable sales that would not otherwise occur.
A common obstacle to a needed 1031 exchange is the inability to match the equity and debt of the new property with that of the property being sold. This is especially acute with the current lower loan to value purchase loans. Sellers with high debt cannot replace the debt so the exchange fails; there is no sale. Here, a zero coupon 1031 security may save the sale.
1031 securities may offer the seller specific investments with specific debt (usually non-recourse) and projected cash flows based upon actual rent rolls. In addition, it is frequently possible to match the required debt and equity – 1031 exchanges require the replacement property to meet or exceed the debt and equity of the relinquished property.
1031 securities provide a tool box of options for owners and brokers. The use of these securities may well result in sales that would not otherwise occur. The real estate securities industry has applied basic real estate principles to the securities structure and has created products of great utility to the real estate industry. While they may not always be of use they may save your deal or even create a new one.
Jack Creighton is managing partner of Sourcenet Investment Services LLC in Hingham.
