With the rebound of commercial real estate markets nationwide has come renewed interest in Gulf Coast properties in which capital gains taxes can be deferred, sometimes indefinitely.
So-called 1031 exchanges occur when buyers sell commercial property, deposit the proceeds with an intermediary and then acquire new property within a specified time period.
The U.S. Internal Revenue Code Section 1031 rules have become especially appealing to retirees and new residents who wish to trade holdings elsewhere for properties in Florida, experts say. And with nearly 1,000 new residents migrating to Florida daily, the appetite for 1031 deals is waxing significantly.
“It’s been steadily increasing over the past year,” says Theresa Knower, a senior vice president with Midland IRA & 1031, a Fort Myers firm that specializes in 1031 exchanges as a “Qualified Intermediary.”
“We’ve seen a number of customers from up north who move here and want to have properties closer to them. And we’re seeing more examples of even sometimes complicated transactions being executed in shorter and shorter periods of time.”
The time element is critical to 1031 exchanges because under IRS rules, property owners have just 45 days from the time they sell a property to identify and lock in to a second property to defer tax capital gains and other tax payments. The second property in such an exchange must be purchased within 180 days of the initial closing to take advantage of the 1031 deferment, experts say.
The 1031 rules allow buyers to acquire more income-producing property than they would without the exchange, because the money that would go toward paying double-digit capital gains taxes is instead be re-applied to purchase another property.
Experts note 1031 exchanges also are helpful for passing wealth to heirs.
“It can be a very good estate planning tool for people,” says David Bone, a Sarasota attorney and qualified intermediary who estimates he has participated in thousands of tax-deferred exchanges.
IRS rules dating to 1979 specify that buyers must acquire “like kind” property of at least an equal value to what is being sold initially to defer taxes.
Matt Stepan, a Premier Commercial real estate agent in Naples and Fort Myers, notes that “like kind” does not mean similar assets, however. In other words, an apartment project may be sold and taxes deferred by buying an office building.
In one recent deal, Stepan and his brokerage partner acquired a multibuilding industrial park in Fort Myers and roughly $25 million in other commercial assets on behalf of an Ohio client who had sold a portfolio of mobile home parks to a real estate investment trust.
“The 1031 exchange allowed them to defer the capital gains on the sale and redeploy the income they had earned,” Stepan says. “It gave them the opportunity to reinvest capital they would have otherwise paid taxes on and buy additional property, in our market.”
Although 1031 exchanges can be useful for estate planning and they defer tax payments until either the owner dies or sells an asset, there are potential drawbacks to them.
“It can be very difficult to get all the ducks you need to in a 1031 exchange in a row in a limited amount of time,” says John Stone, managing director with commercial real estate brokerage Colliers International, in Tampa.
Such exchanges often also involve broad geographies that make coordination difficult.
Stone recalls a recent deal that involved an older investor interested in conducting a 1031 exchange. Stone’s client was located in Miami. The property he wished to sell was commercial land in Los Angeles, and the property identified for the 1031 exchange was a multifamily complex in Orlando.
Stepan, too, cautions that 1031 exchanges require patience, preparation and skill.
“I’ve seen people panic when engaged in 1031s because they know the clock is ticking, and they end up buying something they shouldn’t just to fulfill the requirements,” he says.
“Good preparation is the key,” Stepan adds. “You need to know upfront what area and asset class you want to invest in, and you need to have a team put together, consisting of a broker, an intermediary — often a CPA — and an attorney. You really have to get things together in a 1031 before the first property in the whole transaction closes.”
“There are a lot of people I think now feeling the urgency to lock in, they don’t want to wait for 180 days to elapse,” Knower says.
That can be a drawback as well. Under IRS rules, investors hoping to execute a 1031 deal must lock up their capital from a property sale with a Qualified Intermediary like Midland, which escrows it while the second property or properties in the equation are identified and purchased.
Though many investors appreciate the continuity, some balk at tying up proceeds. Knower says at Midland, only 5% of those wishing to complete a 1031 exchange fail to meet the required deadlines and must pay capital gains taxes.
That percentage could change, however, as sought after Gulf Coast properties get snapped up.
Stepan and others say in addition to time constraints, the biggest obstacle to completing a 1031 deal is that there are so few properties in the region that remain viable for an exchange.
“There are so many people looking to reinvest here now that it’s been tough in many cases identifying properties to purchase,” Stepan says.
Still, Stone contends 1031 exchanges will remain robust as long as commercial real estate markets across the country stay healthy and Florida gains residents interested in redeploying capital from elsewhere.
“As long as there continue to be commercial property sales, there’s a good likelihood that there will continue to be those interested in 1031 exchanges,” he says. “Right now the market is very active: There are many more buyers than sellers in Florida.”
If an investor has a $400,000 capital gain from the sale of a property, he would incur roughly $140,000 in taxes, leaving $260,000 for reinvestment.
Under a scenario with a typical down payment and leverage, that investor would be able to buy new property totaling $1.04 million.
With a 1031 exchange, however, that same investor would be able to purchase about $1.6 million by using the entire $400,000 proceeds from his initial sale.
Source: Asset Preservation Inc.
– K.L. McQuaid