Section 1031 of the Internal Revenue Code allows you to defer federal taxes by swapping real property for like-kind property.
For years, tax advisors have been recommending a 1031 strategy whenever real estate developers and owners are ready to harvest their gains.
Today, with real estate valuations at record highs and capital gains tax rates at record lows, there is a good chance a 1031 exchange strategy could defer taxes but lose profits. You may be better off to recognize the gain and pay your taxes.
How They Work
Properly structured, a 1031 exchange will avoid current taxable income from disposition of real property. Under Section 1031, taxes are deferred when similar assets are exchanged without a "cashing out."
If a sale produces cash or non-like-kind property ("boot"), you have a cashing out and all or some of the gain is currently taxable.
The definition of "like-kind" property can be "kind" (you can swap an apartment building for an office building; improved property for unimproved property) or "unkind" (cannot swap real property held for investment for real property held for personal use.)
Over the years, rulings and decisions have clarified and generally made more liberal the definition of "like-kind property." In addition, there are now well-defined rules for non-simultaneous exchanges where replacement properties are acquired after ("forward" exchange) or before ("reverse" exchange) disposition of the relinquished property.
Further, there are prescribed rules for swaps of fractional ownership (tenancy-incommon) interests. As a result of these changes, we now have what seems like a cottage industry of funds, brokers and consultants ready to help you avoid current taxable income through tax-deferred 1031 exchanges.
Supply meets demand
Many owners and developers are aware of the benefits of Section 1031. Throughout the last decade, the market responded with a convenient replacement property, the single credit-tenant net-lease real estate investment.
A common example is an "A" rated public-company tenant in a single-use facility (say a CVS Pharmacy) at the corner of Main and Main. With non-recourse financing, this investment is like clipping highly rated bond coupons; even better since the investment is made in part with dollars that would have gone to Uncle Sam.
Supply slows, demand rises
In recent years, it seems every real estate publication or seminar has something on the benefits of a 1031 exchange. This combined with an understandable bias to avoid current taxes has continued to stoke the demand fire. Combine increased demand with low interest rates and you have historically low cap rates and correspondingly high valuations of the single credit-tenant net lease replacement properties.
On the supply side the "A" credit-tenants of the world are now more inclined to hire developers for a fee and own rather than lease, or exercise their right to purchase existing prime locations.
Not to be left in the dust, the 1031 cottage industry has responded. The problem is the characteristics of the supply side response. Your choices are either substitute the credit tenant with a non-credit ten ant (trade CVS for fast food) and/or give up Main and Main for a less desirable location.
Pros and cons
1031 exchanges work extremely well when the replacement property retains or improves on its going-in valuation, but a declining valuation can take a toll on the benefits. Retention or improvement of value could be caused by declining interest/cap rates, improved credit quality of leases, or a location that holds or improves value over the years.
Ongoing analysis, however, has found that 1031 exchanges aren't always the best strategy. Sometimes selling the property outright, paying your capital gains tax and putting the net proceeds to work in another investment vehicle is a much better approach.
The risk is that you could roll your cash proceeds into an investment that does not retain its value or does not perform at or near that of alternative investments, including your core business.
Keith Gambrel is a CPA and partner in the real estate services group at Indianapolis-based accounting firm Katz Sapper & Miller. Views expressed here are the writer's.