FEATURE ARTICLE, SEPTEMBER 2011

1031 EXCHANGE ACTIVITY PICKS UP
Understanding fundamentals of 1031 exchanges is more important than ever as owners look to preserve equity.
Ricky B. Novak

Between 2002 and 2007, real estate investors and developers built tremendous wealth and preserved significant equity by using tax-deferred exchanges under Section 1031 of the IRS Code. During the economic downturn, exchanges were used less frequently for preserving equity from the appreciation of real estate — mainly due to offsetting losses from other transactions or a general erosion of equity altogether. More often, over the past few years taxpayers used exchanges as a strategy for deferring potential tax liability from short sales and foreclosures.

However, taxpayers are again relying on exchanges now that some real estate assets are selling at a gain.

Exchange Trends

In August 2010, the volume of exchange transactions began to increase significantly. This trend started with developers and investors selling singular assets and asset portfolios to large REITS and private equity funds that were looking to purchase assets with cash. Class A and B multifamily assets and single-tenant NNN assets backed by national credit tenants were their typical targets. These purchases fueled the start of new construction exchanges by many of the selling developers, especially in the single-tenant NNN industry. The exchange trend has spread to larger, more institutional assets in the office and retail sectors. Grocery-anchored retail centers have also been at the center of exchange activity. The common underlying characteristic of the assets being sold in these exchanges has been the stability of the asset, often stemming from strong credit tenants.

Exchange Alternatives

Most taxpayers are familiar with the most common exchange transaction, the forward-delayed exchange. In these exchanges a taxpayer sells their Relinquished Property to a third-party purchaser, uses a Qualified Intermediary (QI) to hold their exchange proceeds, and eventually acquires Replacement Property from a different third-party seller. Many taxpayers are not aware of other exchange structures that have been used for years by savvy real estate investors and developers.

These other strategies include reverse exchanges, whereby Replacement Property is acquired prior to the sale of the Relinquished Property. In these transactions, the taxpayer must rely not only on the assistance of a QI, but must also engage an Accommodating Titleholder (AT) to take title to the targeted Replacement Property. The AT, which is often a limited liability company that is owned by an affiliate of the QI, will hold Replacement Property on the behalf of a taxpayer until the taxpayer has sold the Relinquished Property.

Additionally, taxpayers may use a construction exchange in order to build ideal Replacement Property or use a leasehold exchange when they wish to build Replacement Property on real estate they already own. Again, an AT must be used to hold title to the property during the period of time when improvements are being completed. These exchanges may also be used in the reverse format whereby a taxpayer uses the AT to start the construction process on the Replacement Property prior to the sale of the Relinquished Property.

Finally, taxpayers should note the ability to complete multi-asset exchanges on the sale of businesses. In these asset sale transactions, a taxpayer will allocate value between the real property and the personal property. Real property includes land and buildings, while personal property may include furniture, fixtures, equipment, vehicles and aircraft. Many taxpayers are unaware of the ability to complete exchanges on the sale of personal property assets, and should note that many types of assets, including art and collectibles, can qualify for tax-deferred exchange treatment.

Exchange Strategy

Choose your Intermediary wisely. In the past, many taxpayers assumed the QI was bound by state or federal regulations. Shockingly, QIs were not held to any such regulation and many taxpayers learned this lesson the hard way. Numerous QIs filed for bankruptcy from 2007 to 2009 for a variety of reasons. In certain situations, the QI absconded with client money. In other instances, the QI commingled client funds and held them in less liquid investment vehicles in an effort to obtain more attractive interest rate returns for the QI’s own benefit. When these investments became truly illiquid, the QI often engaged in Ponzi scheme-type activity whereby the exchange proceeds from new exchanges facilitated by the QI were used to fund other exchanges that were being completed. When transactional real estate came to a halt and there were no new exchange proceeds to cover Replacement Property closings, the QI was exposed for these non-transparent practices and most filed for bankruptcy.

In light of these activities, the federal government and a handful of state governments have enacted or are considering laws that will regulate QIs. Meanwhile, taxpayers and their advisors should always consider the following:

• Make certain the QI uses segregated accounts. Never use a QI that commingles or pools client funds.

• Inquire as to whether the QI carries both Errors & Omissions Insurance and a Fidelity/Crime Bond.

• Look for QIs that will allow the taxpayer to direct where the exchange proceeds are held during the exchange as holding the funds in your bank of choice may help alleviate financial institution concerns and often allows you to directly contact your personal banker to confirm funds are present during the exchange process.

• Consider using a dual-signature account, whereby your signature is required prior to the QI moving the funds out of the exchange account. For larger transactions, the taxpayer may also want to consider using a qualified trust or escrow account as well.

• Ask questions of the QI and demand full transparency of all fees, processes, etc. Carefully select a QI after thoroughly vetting their structure and processes. Remember that bigger does not necessarily mean better. Taxpayers and advisors should make a detailed inquiry of any QI prior to using their services.

Attorney Ricky B. Novak is CEO of Atlanta-based Strategic 1031 Exchange Advisors.

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