Reducing income taxes
One of the thorniest challenges facing holders of commercial real property, both in California and elsewhere, is reducing the income taxes incurred when disposing of highly-appreciated assets. Commercial real estate owners have responded to this challenge by taking advantage of the Internal Revenue Code Section 1031 tax-deferred exchange—in which property that has increased in value is swapped for property of “like kind” to postpone the recognition of taxable gain—as a means of lowering their current income tax liabilities. In recent years, this technique has become particularly popular, with the number of taxpayers using this provision rising substantially.
Section 1031 exchange
However, before deciding to sell your appreciated commercial real property and proceed with a Section 1031 exchange, you, as a prudent investor, should be aware of certain practical issues you will face if you attempt to pursue a Section 1031 exchange in the current economic climate. Failure to take these factors into consideration could result in frustration, wasted time, and disappointment. Even worse, you could end up with a substantial income tax liability if your efforts do not succeed.
Recently, I have heard of some commercial real estate owners, intoxicated by the siren song of high property values for San Francisco Bay Area commercial real estate, who have impulsively decided to sell their holdings to take advantage of the current market, with the idea that they can defer any taxable gains they will recognize through a Section 1031 exchange. Missing from their thought processes, however, is the realization that, while they may enjoy the advantages of a seller’s market in disposing of their “relinquished” real property in the first leg of a standard exchange transaction, they may suffer an equal or greater disadvantage when attempting to acquire their required “replacement” real property in the second leg of an exchange transaction.
This disadvantage is due to two factors. The first, more obvious factor is that these investors will have gone from being sellers in a seller’s market to being buyers in a seller’s market. As much as sellers are in the driver’s seat in many current markets, buyers are left with difficult choices in attempting to acquire quality commercial investments. From highly-competitive bidding for attractive assets, to substantial non-refundable deposits, to short-trigger contingency review periods, today’s commercial real estate market presents buyers with a minefield of potential catastrophes, which must be carefully navigated to avoid disaster.
The second factor is that Section 1031 imposes several rigid timing and identification requirements in order for a taxpayer’s transaction to qualify for tax deferral; if any of these requirements is not met, the exchange will be currently taxable. First, the “replacement” property must be identified within 45 days after closing on the “relinquished” property. Second, the identification of the “replacement” property must be performed according to certain strict limitations. Finally, the acquisition of the “replacement” property must close within 180 days of closing on the “relinquished” property. Given the realities of the current market in this area, it is extremely challenging for taxpayers to satisfy these inflexible requirements, and very easy to fail.
One way for investors to deal with this situation is to be willing to cast a wider net in searching for replacement property. While we have been faced with an acute shortage of available commercial opportunities in the San Francisco Bay Area, other locations are more favorable to buyers, and should not be ignored as potential locations to target a replacement property search. In my experience, it is critical to engage a skilled real estate broker with deferred exchange experience to be able to evaluate, pursue and acquire commercial properties in other areas, and I highly recommend doing so when you are contemplating entering into a Section 1031 exchange.
Another possible solution to this problem is the reverse exchange, in which the replacement property is acquired first before disposing of the relinquished property. By proceeding in this manner, the timing challenges that can arise in tax-deferred exchanges as a result of delays in closing the acquisition of the replacement property can be avoided. While reverse exchanges avoid these timing issues, they have their own difficulties. First, and most significant, an investor must have sufficient capital other than the relinquished property in order to be able to acquire the replacement property before disposing of the relinquished property. Further, the costs associated with the exchange are also higher because, in order to qualify for tax-deferred treatment, title to the replacement property must be held in the name of the exchange accommodator, which will charge more due to this higher risk, until the relinquished property is sold.
While Section 1031 tax-deferred exchanges can provide substantial benefits for owners of appreciated commercial property, pursuing them is challenging at best, and potentially disastrous if not carried out properly. Investors should consult with skilled accountants, attorneys and real estate brokers before moving forward with an exchange to ensure that they are as well-prepared as possible to deal with all possible contingencies.