Dealing with the Internal Revenue Service can often be a taxing exercise, but in the case of one increasingly popular federal statute, commercial real estate owners have an option that might actually keep the IRS out of their pockets.

Referring to Section 1031 of the Internal Revenue Code, a so-called “1031 exchange” allows a property owner to defer the capital gains tax they would otherwise pay in a sale. While the process is accompanied by a complex and stringent set of requirements, a 1031 exchange essentially results in the trading of one asset for another during a prescribed time period. With capital gains tax payments running as high as 30 percent on the profit of a sale, Section 1031 can save substantial sums for even an average investor, helping to fuel its popularity.

For example, an owner trading an office building that had paid $50 million for the asset would have a capital gains tax of $20 million should it later be sold for $70 million. By deferring a capital gains tax of even 20 percent via a 1031 exchange, the owner would save $4 million.

History

The roots of the 1031 exchange harken back to 1979 when Oregon property owner T.J. Starker won a critical court ruling acknowledging he could sell one property and purchase another without paying the capital gains tax – based on the notion that the transfer is one continuous property holding. That victory ultimately led the IRS to issue strict procedures in 1984 and again in 1991 that have further strengthened the understanding of a 1031 exchange, which is also known as a Starker delayed tax-deferred exchange, in honor of T.J. himself.

The 1031 exchange process initially garnered its strongest following on the West Coast, perhaps due to Starker’s geographic presence in that region, but industry observers report the concept is quickly gaining acceptance in the East as well.

“It really is coming around in New England,” said Patricia A. Flowers, an executive with California-based IPX 1031 International Property Exchange. “The trend is definitely upward.”

Practice

IPX is a “qualified intermediary” which authorizes the company to work with clients to develop a 1031 exchange strategy and guide them through the morass of paperwork and requirements which accompany the effort. Flowers has been operating in Boston for the past five years, and said much of her work is aimed at educating the public by holding seminars on the idea and helping people determine whether the exchange concept makes sense for them.

IPX 1031 International Property Exchange has been providing such services for nearly two decades, said Flowers. “It’s all our company does all day every day,” she said. Under the guidelines, an owner has 45 days after the sale of their first property to designate the new asset or assets to be acquired, then another 180 days to complete the sale. As with other aspects of the regulations, those limits must be strictly adhered to in order to qualify as an exchange.

“The time deadlines are very restrictive,” said Flowers. “You need to have a lot of planning and forethought, or it can be a real problem.” One tricky aspect occurs when the seller of the replacement property opts to delay the process, sometimes in order to raise the price as the 180-deadline nears.

Given that possibility, 1031 exchange advisors suggest identifying several possible exchange alternatives in case the initial target is held up indefinitely. One piece of advice offered is to have one deal sure to close in case the remaining options are unable to proceed.

Beyond the tax implications, a 1031 exchange may make sense for other reasons as well, including the opportunity to get rid of an undesirable property and to purchase a more desirable asset. An owner of an older office building may want to trade up for a better facility, for example, either to improve cash flow or reduce maintenance.

Locally, Flowers said she believes 1031 exchanges will only continue to increase, although she added there is one current issue: a lack of suitable investment properties to pursue in some areas and some product types. With institutions and overseas capital clamoring for multifamily and retail buildings, an owner conducting a 1031 exchange may be priced out of a deal or even unable to find an asset to buy at all, said Flowers.

“It has been very difficult for people to find replacement properties,” she said. “It’s a great market to sell in right now, but when you turn around to try and buy something, that can be a problem.”

Such a dilemma has kept investment sales down of late, according to Finard & Co. Principal William J. Beckeman. While there are many owners of shopping malls who would be interested in disposing of their assets as part of a 1031 exchange, Beckeman said the scarcity of other investment vehicles has been a stumbling block.

“If we had a more balanced market right now, it would help,” Beckeman said. “People just don’t feel comfortable there is anything for them to exchange into.”