Follow Up on 1031 Exchanges

A few weeks ago I posted Part 1 of a Series on "Why TICs are good" which explained what a 1031 exchange is. As a follow up to that discussion, I recently came across this very interesting article which offers some tips on the nuances of a 1031 exchange. I won't repeat the article here, but a couple interesting things to know are:

1) Foreign properties are not considered "like-kind" for the purpose of a 1031, regardless of what they are, and

2) "Personal property may be exchanged under [section]1031. However, to qualify it must not only be exchanged for other personal property but must be exchanged for personal property of the same "like class" property or within the same product class as set forth in the NAICS manual.

Happy Reading!

Why TICs are good! - Part 2 - Why a 1031 TIC?

In my last post I explained what a 1031 is, and showed you the advantages. Now, let's go back to Isabella Investment. Isabella has decided that she'd like to save the 27% in taxes and go with a 1031 exchange. However, the idea of owning another commercial or investment property is really not all that appealing to her. She's selling her office building, because she's sick of the headaches that go with being a landlord. Furthermore, she's nervous about having all of her money tied up in one small building in New York City. She wants to diversify, and she would love to invest in a big office building, one she simply couldn't afford to own by herself. To make things even more complicated for Isabella, according to the 1031 statute, she must identify buildings in which she would like to invest within 45 days in order to defer taxes!

Well, incredibly enough, Isabella is the ideal 1031 TIC investor. But what's a TIC? TIC stands for Tenant in Common, and it is simply a situation where multiple people own one building. It could be you and your uncle George, or in the case of the TICs Grubb & Ellis offers, they are securitized investments regulated by the SEC.

So, how does it work? OK . . . here it goes. Before Isabella sells her office building, she identifies a "qualified intermediary" (basically an escrow agent). When she sells her building, the qualified intermediary holds the money temporarily. Once she sells the building, the clock starts ticking, Isabella has 45 days to identify up to 3 buildings for potential investment, and up to 6 months to close on one or more of these properties. She calls up Grubb & Ellis (or another TIC provider), and is presented with several opportunities. The buildings are located throughout the country, and in different industry sectors. After careful deliberation, Isabella decides she is interested in a golf course in Florida, a medical office building in South Carolina, and a retail shopping center in New Jersey (yes, these are all considered to be "like kind" for tax purposes). It has now been a month since Isabella sold her office building, so she has 5 months to go to close on properties.

Isabella decides she would like to invest in the medical office building, and the retail shopping center. There is $30 million in total equity invested in the medical office building, and Isabella invests $1 million. She receives a deed for 1/30 of the property. There is $15 million in total equity invested in the retail shopping center, and Isabella invests $1 million. She receives a deed for 1/15 of the property.

For the next 3-8 years Grubb & Ellis (or a similar company) manages, leases and handles all maintenance on Isabella's investment properties. Meanwhile, Isabella receives checks for her share on the profit from leasing the buildings. In 3-8 years, the properties are sold and Isabella receives her share of the profit on the sale. She then must decide again, to defer or not to defer.

Why TICs are good! - Part 1 - What is a 1031 Exchange?

As you may know, Grubb & Ellis recently merged with NNN Realty Advisers. As a result of the merger, Grubb & Ellis is now, not only a corporate real estate services firm, but also a leading sponsor of real estate investment programs. Most notably, Grubb is now the number one sponsor in the country of tax-deferred 1031 exchanges via tenant-in-common in partnerships.

What does that mean? Glad you asked!

Let's start off with a primer on 1031 exchanges. 1031 refers to a section of the Internal Revenue code - here's what it says:

"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."

Quite simply, the government will let you defer taxation on the gains from a sale of commercial or investment property if one invests in similar property. Here's an example:

Isabella Investment owns an office building in New York City. She purchased the building in 1990 for $300,000. It's now 2008, and she decides to sell the building. In this market, she can get $2 million for the building. That's a capital gain of $1.7 million. This gain is taxable in the following ways:

1. Federal capital gains tax of 15%


2. State and (in the case of New York City), city capital gains taxes. These income taxes depend on your tax bracket, but the rule of thumb, is that these add up to an additional 12%.


3. Depreciation Recapture tax - a tax on whatever amount of money you depreciated (on a straight line basis) for tax purposes. Recapture tax is 25%.
   
4. Excess Depreciation Recapture tax - a tax on certain structures and improvements that you've depreciated on an accelerated basis. This is taxed as normal income, and is up to 35%.


5. Real property transfer taxes. In NY state, this tax is .4% of the full purchase price. Additionally, New York City applies a 2.625% transfer tax.

In all cases, the first 4 taxes on this list may be deferred. Only in special cases may the transfer tax be deferred as well. Let's see how this plays out for Isabella - we will assume that Isabella fully depreciated her office building:

Scenario 1 - Isabella does not do a 1031:

Sales Price: $2 million
Capital Gains: $1.7 million
Federal Capital Gains Tax: $210,000 ($255,000 - $45,000 covered by recapture tax)
State & City Capital Gains Taxes: $204,000
Depreciation Recapture Tax: $75,000
Excess Depreciation Recapture Tax: For the purpose of this example, we'll assume this doesn't apply although it would likely only make her taxes higher!
Transfer Taxes: $60,500
Total Taxes: $549,500
Total Tax %: 27.5%
Equity to Reinvest: $1,450,500

Scenario 2 - Isabella does a 1031 exchange:

Sales Price: $2 million
Capital Gains: $1.7 million
Transfer Taxes: $60,500
Total Taxes: $60,500
Total Tax %: 3%
Equity to Reinvest: $1,939,500