Tuesday, November 12, 2019
Text Size

Under Internal revenue Code 1031 there is an available method for exchanging or selling and buying commercial real estate while deferring the income tax liability. There are several specific rules that must be followed to the letter in order to take advantage of this tax break. The rules are not difficult but it is important that an investor know these rules or utilize a knowledgeable real estate broker trained in 1031 Tax Free Exchanges and a Title Company that has the training and special license to assist in the transaction or your transaction could be disallowed as a tax free exchange under IRS Code 1031. Note that the 1031 exchange is called a “tax free exchange” when in fact it is a tax deferral.

Example: You sell an office building with a cost basis of $ 2 Million for a price of $ 3 million where you would owe tax on the $1 Million gain. Instead you choose to use a 1031 exchange and you trade your $ 3 million property for a $2.5 Million property. As a result you take your cost basis of $2 Million to the new property and you own a $2.5 million property with a $ 2 Million cost basis instead of owning a $3 Million property with a $ 2 Million cost basis. You don’t own any income tax until you actually sell the new property for cash.

Note: You should discuss your particular tax situation with your Accountant before proceeding with any 1031 Exchange.

There are reasons other than Taxation for owners of commercial real estate to utilize exchanging their real estate instead of just selling their property when they no longer want or need to own that particular asset. There are two national groups of experienced commercial real estate investors and brokers today that meet every two months and also maintain an ongoing group web site with listings of commercial real estate available for exchanging. The two groups are the National Council of Exchangors (NCE) and the Society of Exchange Counselors (SEC). These commercial real estate brokers bring properties that they have “exclusively listed” or own to these three day meetings and work with other investors and brokers in search of a trade or multiple trades that would be beneficial to their clients. Seventy Five percent (75%) of the people in the meeting actually are the “owners” of the real estate being offered. Exchanging is new to many brokers and real estate investors and therefore the term “counselors”. Brokers “counsel” their clients as to the value of exchanging their real estate so they can fully understand the procedures and the benefits.

Some may have a preconceived idea that investors just want to trade property that is undesirable or overpriced. This is far from the truth. Following is a list of just a few of the reasons why investors consider exchanging their real estate assets:

1. An investor wants to sell his office building in Arizona and buy another office building in Florida where he is moving to. He has a low cost basis and does not want to pay the Tax or Traditional bank financing is difficult to obtain and buyers want to buy his property but they cannot secure a loan….. Answer: Trade your Arizona office building for a Florida office building

2. Partners in a multifamily property no longer want to be partners with each other…..Answer: Trade the single multifamily property for condos or fourplexes that can be owned separately or sell half the building for cash and take on a new partner.

3. An investor wants to have a real estate investment but he does not want the management duties associated with his Convenience Store (a business)…..Answer: Trade your Convenience store for a more passive investment like an office building or even raw land.

4. An investor has raw land but needs cash and an income and potential Buyers are having a hard time securing a traditional bank loan even with a 50% down payment…….Answer: Trade your land for part cash and an income producing asset like an office building or retail center.

5. An investor has duplexes and fourplexes but wants to trade up to a larger investment…. Answer: Trade your duplexes and fourplexes plus cash for an Apartment Building.

6. An investor needs cash because he has another investment where the bank loan is coming due and the bank is unwilling to renew the loan due to bank regulators requiring the bank to reduce its commercial loan portfolio……Answer: Trade your two office buildings valued at $5 Million for an office building valued at $3 million plus $2 Million in cash from the other party to pay off your other bank loan.

There are many possible reasons that an investor may want to get out of his investment and yet remain an investor in an asset that is a different type of property, located in a different geographical area or an asset that has a larger or smaller value. In today’s environment the lack of liquidity or traditional bank financing has substantially increased the demand for “Exchanging” Real Estate. An investor has an advantage in the “Exchange” if he is able to “Add” something to the equation. This is called a “Can Add”. Maybe an investor is offering to add a second property to the trade, property management services or cash.

Example: Investor “A” has a $3 Million asset that is not performing or not producing a market return. He will exchange this asset for a $5 Million property and offer to “Add” $2 Million in cash as an incentive for Investor “B” to exchange his property which is a better performing asset. Investor “B” will be eager to make this trade even if the property he receives has an inferior return if he has real need for the $2 Million in cash.

Following are two examples of Exchanges that I personally completed recently:

1. Large Residential Estate Home:

I had a client with a lakefront estate home in Texas valued at $1.6 Million. The owner had the house on the market for over two years without a buyer. He had already purchased another home and he wanted to rid himself of the $60,000.00 in annual negative cash flow from property taxes, insurance, maintenance, repairs and the monthly duties of dealing with the house. The house was more difficult to sell in today’s market as financing is more difficult to obtain with higher priced homes. Lenders want a higher down payment, higher credit rating and higher interest rates as these loans don’t qualify to be sold in the secondary market to Fannie Mae or Freddie Mac.

I knew of a Texas bank that had two foreclosed retail centers in New Mexico. These properties are classified as (REO) or Real Estate Owned by the bank regulators. One of the centers was 100% occupied and provided a net operating income of $125,000.00 which is an 8% return on a $1,600,000.00 purchase price. The other center next door was an empty building as the previous tenant had recently moved out. I knew that banks had difficulty with the Bank Regulators and they are penalized with higher capital reserve requirements for having “Commercial REO” on their books. The Regulators today much prefer a bank to have residential loans on their books as they view this as less risk to the bank.

My client exchanged his $1.6 Million house for the $1.6 Million retail center as an even trade and agreed to buy the other retail center for $1,000,000.00 with the bank providing financing on the sale. The bank in turn listed the house with Cummings Realty and I sold the house to a buyer from Tennessee with the bank providing below market financing which the buyer found most attractive. The client got out of his house and the $60,000.00 negative cash flow and the $125,000.00 net operating income from center #1 more than paid for the cost of carrying center #2 until it could be leased. The bank got rid of two commercial REOS and got a performing residential loan form financing the house sale and the house buyer got an estate home with below market financing. Everybody wins….!

2. Golf Course:

I had a client that owned a golf course in Texas. It was a small golf course which a typical large investor would not be interest in. I felt the best buyer was a Mom and Pop buyer looking for a retirement investment or a PGA Pro or Superintendent that wanted to own his own golf course. However, most of these type investors would require “seller financing” as traditional bank financing on the golf course would be difficult to obtain. The owner wanted $1.5 Million including 22 residential lots and 18 acres of development property. The owner would not separate the land from his golf course and he would not offer seller financing. The main motivation for the client was to get rid of the day to day responsibilities of managing the golf course.

I exchanged the golf course and extra land to a couple investors who owned some improved development land around a retail development in Texas. They wanted to trade for an income producing property in order to activate their “dead equity” that they had in their land which was costing taxes and insurance but not producing any current revenue. The investors surveyed out the extra land and kept it as a future investment. They relisted the golf course without the extra land with my golf course brokerage company, Golf Course Brokers, Inc., and offered seller financing. I sold the golf course to a PGA Pro three months later. The investors now have a Note Receivable producing an income, the old golf course owner has a solid investment that does not require any management and the PGA Pro now owns his own golf course. Everybody Wins…..!

I hope this general explanation of Real Estate Exchanging is helpful to you. The IRS Code 1031 and Exchanging in general are valuable tools to produce a Win-Win situation for real estate investors. I am an Equity Marketing Specialist (EMS) and a member of the National Exchange Counselors (NCE) and a participant at the Society of Exchange Counselors (SEC) as well. You can learn more about these organizations at www.nce1031.net and www.secounselors.com. Please contact me for more information or to explore how an Exchange may be beneficial to you and your real estate investment portfolio.

Tommy Cummings, CCIM, EMS
Cummings Realty
Ph: (936) 788-4622
This email address is being protected from spambots. You need JavaScript enabled to view it.

Cummings Realty

Tommy Cummings
(936) 788-4622 Cell
This email address is being protected from spambots. You need JavaScript enabled to view it.

Vickie Cummings
(936) 577-6331 Cell
This email address is being protected from spambots. You need JavaScript enabled to view it.

Fax (713) 583-0344