Tax-deferred exchanges of commercial property can postpone and even eliminate federal taxes due on the sale of properties that qualify for tax-deferred status. Since 1921, the IRS Section 1031 exchange rules have been in place with the intent and effect of generating capital for investment. Tax deferment on an exchange of property in “like kind” as 1031 stipulates is effectively an interest-free loan from the federal government in the amount of the taxes that would have been due on a simple sale.
As great as that sounds, navigating the obstacle course in qualifying is a challenge for most, meaning it’s a full-time job for some. Patricia Del Rosso of Inland Private Capital has built a major practice in 1031 transactions, and came to talk about 1031 to clients trying to get their tax-deferred exchange strategies in a row.
Rise In The Investment Market Means Rise In 1031 Demand
“1031 transaction volume has increased over the last 18 months – between 50% and 100% nationwide” said Del Rosso. “The capital markets were in paralysis — potential buyers had to means to buy, which hit commercial very very hard.”. But the new commercial market had more stringent financing requirements. ”Requirements for lower loan-to-value ratios and more restrictive clauses and covenants” means that 1031s loom large as an more attractive source of capital to get a deal done. ”We see more potential exchangers coming off the sidelines and getting the prices they want. It’s uneven – [some markets] are still very bad and will take more time, but elsehwere, you see multiple offers and some move to a new transaction form: setting up auction bid processes.”
Paid-Up Baby Boomers Looking To Sell
DelRosso described a key 1031 demographic: baby boomers, whose interest in tangible assets means they have often invested in and worked/managed commercial property, and are now looking to retire. ”[They] want to parlay their sweat equity and capital appreciation into something with more predictable income. There’s a huge population for this, growing all the time. They consider 1031 because they have held the property for so long. the rents they have received have gone to pay the mortgage… over 10-20 years, they may not have any debt. If they do, it’s probably quite small. typically they have not raised the rent according to market conditions. you often find they have very low returns and they dont even realize it. - some as low as .5 to 2%.”
The Tax Situation
While you may not have access to a seller’s form 1040, you’d be surprised what sellers divulge when talking to a professional. DelRosso explained “They have taken deductions that have brought them into a negative position in terms of the money they’ve invested in the property. They forget they don’t have a zero tax basis, they have a negative tax basis. So they don’t realize when they sell, they have to come back to at least a zero tax basis on the property. They’re surprised they owe taxes on the property at sale time.”
The 1031 benefit is the natural fit for that situation – but of course an exchange needs to take place, so property to exhange needs to be identified and strict timeframes for the exchange under 1031 must be met. Del Rosso’s strategies and tactics here are many, including a Deleware Statutory Trust, a business trust called into exchanges partially for the purpose of facilitating a 1031 exchange.
You can get a full audio recording of Patricia Del Rosso’s presentation to REALTORS Conference & Expo 2012 “Increasing Your Market Share Via 1031 Exchanges” at PlaybackNAR.