Why Is Now The Perfect Time To Do A 1031 Exchange?

By Stephen A. Wayner, Esq., CES

Between 2000 and 2004, the residential real estate markets grew at a phenomenal pace. Most investors can look at the value of their real estate investments today, as compared to 5-6 years ago, and notice that the values of their homes, vacation residences and investment properties have more than doubled during that time span. Unfortunately, real estate prices over the past 8-12 months have been marching to a different drummer. In fact, for almost a year now, the real estate market has been wobbling or even backsliding a bit.

Investors are understandably nervous. They want to protect and lock-in the gains that they have seen so far but they do not want to write the IRS a check for 20-30% of their gains if they were to cash-out of the market. Happily, Code Section 1031 can provide them the opportunity to lock-in their gains without writing a check to the IRS, while moving their funds into a more conservative, defensive investment.

Why 1031 now? Enough time has elapsed since we have seen a truly hot real estate market that the investor can now feel confident that the high double-digit gains he experienced during the prior 4-5 years are not soon to return. At the same time, commercial property values have been enjoying a measure of consistency and stability not seen in the residential real estate market.

While the residential market is cooling, the commercial market is heating up. According to David Lereah, chief economist for the National Association of Realtors, the fundamentals of the commercial market are solid. “Vacancy rates are declining in all of the major commercial sectors, and rents are rising at healthy rates,” he said. Office vacancies are at the lowest level since 2001. By the end of this year, office vacancy rates are projected to drop once again, while office rents are expected to rise 5.0% in 2006.

In addition to the commercial office market, the apartment and multi-family rental market is continuing to tighten, with vacancy rates forecast to drop to an average of 4.5 percent this year from 5.2 percent in 2005. Average rents for multi-family properties are projected by the NAR to increase by 5.3 percent during 2006.

The contrast of the shaky residential housing market consisting of vacation homes, condos and speculative construction projects; with the consistently solid fundamentals and glowing economic outlook for the commercial real estate markets, make right now the perfect time for the investor to re-balance his real estate portfolio. Savvy investors are taking their housing market gains off the table, and rolling these gains over into the commercial sector. And savvy investors do not pay unnecessary taxes!
 

Exchanging High-Risk "Growth" Properties Into Lower Risk "Income" Properties.

The concept is that the same strategies that work for stocks and securities through the Dow Jones and NASDAQ’s boom and bust cycles, will work for real estate investments during real estate’s boom and bust cycles.

At the end of a bull market in stocks, investors move from high-risk, growth stocks that have clearly reached their peak, into conservative, defensive, dividend-paying stocks or even bonds in order to protect the built-in gains that the investors racked-up while the market was soaring. In that same vein, the strategies that worked for real estate investors during the strong bull markets of 2001-2004, will need to be re-structured during times when real estate prices are wobbling or beginning to ebb.
 

How can real estate investors "rotate" their portfolios to protect their gains? In taxable stock accounts, the securities investor must worry about giving back some of his gains through payment of capital gains and state income taxes when he or she "rotates" the investments in his or her portfolio. Fortunately for real estate investors, Code Section 1031 permits investors in real estate to change their real estate holdings from high-risk "growth" properties, to lower-risk "income" properties, without having to give up any of their profits to capital gains or state income taxes. To do this, investors should be looking to sell or exchange out of these types of properties:

High-Risk/Growth Properties

1. condominium units
2. debt-financed acquisitions with thin capitalization (low downpayment)
3. property purchased under development contract
4. development units recently built
5. vacation properties
6. raw land in developing areas
7. high-income or luxury single family residences.

Following the sale of these high-risk properties, the proceeds from the sale should be re-invested, within certain time limits, into lower risk properties that still have strong fundamentals (such as limited quantities with corresponding high demand), and a record of growth and stability. In order to comply with Code Section 1031 and avoid paying federal and State income taxes on the built-in gain from the high-risk properties, the investor will need to use a Qualified Intermediary to conduct the sale. The following types of properties are on the shopping lists of perceptive and well-informed real estate investors:

Lower-Risk/Income-Generating Properties

1. strip-malls under current lease
2. office buildings with tenants
3. multi-family units with tenants
4. warehouse/storage properties under lease
5. single-family rental properties in middle-income markets
 

Exchange Out Of High-Risk Markets And Into Low-Risk Markets.

Gains in the residential real estate market since 2000 have not been uniform and across the board. Certain markets have exploded, with demand for housing far outstripping supply. This imbalance caused a temporary market condition where sellers in certain markets were enjoying annual average increases in property values exceeding 25% per year between 2000-2004. If you were the lucky recipient of this type of growth in the first half of the decade, you should be giving great consideration to the idea of exchanging into property with a lower risk profile. Supply and demand imbalances are in the process of being corrected, through construction of new homes and conversions of existing apartment units into condominium units. In some markets, the number of new condominium and single family homes under construction is so large, that formerly-hot regional markets have reached or exceeded the saturation point.

Markets where extraordinary gains were experienced during the first half of this decade are the same markets that now carry the largest risk of price drops. Investors who own single-family residential investments in these markets are encouraged to diversify their investments into non-residential properties, or residential properties in markets that are not so vulnerable to large losses. Some of these markets are:

High-Risk Markets:                Lower-Risk Markets:
S. Florida                                     Midwest
California                                     Northeast Corridor
Las Vegas                                   South (not Florida)
Washington, DC                            West (not California)
Seattle
New York City

Rebalancing a Real Estate Portfolio Tax-Free. In order for an investor to re-balance his or her real estate portfolio away from high-risk holdings, he or she will need to be selling real estate that has accumulated built-in gain. Ordinarily, when an investor sells appreciated assets such as stocks, bonds, or real estate, he or she is faced with Federal Income Taxes on these gains, at the flat tax rate of fifteen percent (15%), in addition to State Income Taxes on the gain that vary from zero to 9%, for an overall tax rate between 15-24%. Giving up 15-24% of their gains to the IRS every time the market changes its long-term outlook is a painful solution to the problem of risk exposure.

Fortunately, for real estate investors (unlike investors who hold stocks and bonds) , Internal Revenue Code Section 1031 permits the investor to sell his or her risky real estate holdings without paying taxes upfront; provided that the investor reinvests the proceeds in another real estate investment within certain time limits. Consequently, the strategy of dumping ones risky real estate holdings and buying into income generating, fundamentally stable real estate investment can be done on a tax-deferred basis, thus permitting the real estate investor to maximize his or her net wealth.