1031 Exchanges Come Back…In A Big Way

Streetwise Investor, Robert Knakal

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Welcome back old friend! Yes, we have seen a re-emergence of the blessed 1031 tax-deferred exchange in recent weeks, and what a welcome sight it is.

The opportunity to protect hard earned equity in the sale of an investment has been available to investors since 1921. However, this part of the tax code was so complex that only a small segment of the investment community took advantage of this mechanism.  In 1990, the Omnibus Budget Act provided more widespread access to a broader set of investors as this option was clarified and simplified. Section 1031 exchanges are often mischaracterized as “tax free” when they are actually “tax deferred”.

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The theory behind this mechanism is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay taxes. Only the form of investment has changed, therefore, it would be unfair to collect a tax on a “paper” gain.  When an investor utilizes this mechanism, the deferred gain is payable when the replacement property is sold and is not part of yet another exchange. At that point, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

1031 exchanges in the investment property market have been growing in popularity since the mid-90s and fueled a majority of transactions in the mid to late 2000s. With falling property values and transaction volumes beginning in late 2007, we saw a significant reduction in 1031 transactions.

In previous StreetWise columns, I have gone into detail about the supply / demand imbalance and the fact that the volume of sales was so low due, mainly, to lack of supply as opposed to waning demand. The supply of available properties for sale is generally fed by discretionary sellers. When value falls, as it has done since 2007, discretionary sellers withdraw from the market and the supply is then fed by distressed sellers. Distressed sellers have not fed the supply in numbers which were expected because everything that has occurred from a regulatory perspective has allowed these sellers to avoid dealing with their distressed assets.

Recently, we have seen the flow of distressed assets begin to loosen as banks and special servicers are beginning to clean up their balance sheets and portfolios. Simultaneously, we have seen discretionary sellers returning to the market. The tangible evidence that this is actually happening can be seen in the 1031 activity we have seen recently. Distressed sellers are rarely left with any equity to reinvest in the form of a 1031 exchange. Discretionary sellers, on the other hand, often have significant equity to redeploy via this tax-deferred vehicle. We are, once again, seeing sellers ask for flexibility in closing periods to provide them with better chances of being able to effectuate an exchange.

During the past 4 weeks alone, we have signed 12 contracts with purchasers who are investing 1031 funds. Moreover, we are receiving multiple calls each day from investors who are looking for properties to complete exchange transactions. This is certainly reminiscent of 2006 and 2007 when so many transactions were motivated by tax-deferment. The demand side has been very strong for quite a while as institutional capital has returned to the market, joining the high-net-worth individuals and families which have dominated the horizon for the past couple of years. Foreign high-net-worth investors are present in rapidly growing numbers and the re-emergence of 1031 capital adds more pressure to already overwhelming demand for investment properties.

Don’t mistake my perspective as I am not suggesting that market conditions are back to the go-go, bubble inflating, years of 2005 to 2007. I am, merely, passing along a trend that we are seeing which has, for the most part, been absent for quite a while. It is yet another sign that the recovery is upon us.

From an intermediary’s point of view, or anyone’s, who is reliant upon transaction volume for their livelihood, it is positive to see this type of activity returning to the market. To the extent that distressed sellers continue to dispose of assets and discretionary sellers return to the market, transaction volume has no choice but to increase. As sellers with real equity sell, each transaction is likely to stimulate another transaction as a 1031 is contemplated.

This trend certainly bodes well for our projection that transaction volume will increase by about 40% this year over last year. Welcome back old friend, indeed!

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.

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