HOW EXCHANGES WORK
In a 1031 exchange - also called a property flip - investors have 45 days to identify three potential replacement properties and a 180-day period that runs simultaneously to the closing. Exchangers must reinvest all proceeds, and a third-party intermediary - also known as an accommodator - must hold the monies in trust.
Equity held by the investor in the new property must equal or exceed the equity held in the previously owned property. Exchanges can range from a simple two-property swap to a multi-legged, multi-property deal that involves a "construction" exchange or a "reverse" exchange, where an investor buys the replacement first before selling the exchange property.
Rand Sperry, CEO of Sperry Van Ness, recounts a succession of personal 1031 Exchange investments he started in the 1990s when he bought a weathered shopping center, Dove Canyon Plaza in Rancho Santa Margarita, Calif., for $2.8 million.
"People made fun of me and said, ‘You're an idiot. You must not know anything about retail,'" Sperry recalls. "But I knew it cost about $13 million to build, so it was a no-brainer because it was well under replacement cost. We fixed it up and methodically leased it up, then sold it for $8 million. Then I bought two other buildings in an exchange in Montclair and Riverside for $5 million each."
Each of those buildings has risen about $2 million in value. After they are fully depreciated (for tax purposes), Sperry will exchange the buildings and "we could end up with $20 million in assets in about a 10-year span," he says. "Most folks could live pretty well off that."
GROWING INVESTOR AWARENESS
While investors from Main Street to Wall Street are wising up to the tax-saving properties of the 1031, some potential exchanges still slip through the cracks. A panicked New York investor recently placed a distress call to the Investment Exchange Group, based in Denver. The woman had just sold an investment property for about $5 million that she had originally acquired for $1.25 million.
Nice problem? Well, it appears no one bothered to tell her about a 1031 exchange, which would have enabled her to roll over the sale proceeds into another investment property, tax deferred. "Her realtor didn't tell her about 1031, her attorney didn't tell her about a 1031, so she took a $4 million capital gains hit and will face a million-dollar tax bill," says attorney Dan McCabe, president of the national 1031 intermediary firm Investment Exchange Group. "That might be grounds for malpractice."
Why have 1031 exchanges historically been more prevalent on the West Coast? Weller of Deloitte and Touche theorizes that the real estate booms in the West in the 1960s, 1970s and 1980s "made investors more entrepreneurial. Planning in the East is driven more by corporate financial people and attorneys, as opposed to real estate people."
Mirroring industry growth, the Federation of Exchange Accommodators (FEA), an intermediary trade group, has grown from about 100 members in 1997 to over 300 currently, says David Kuns, vice president of Los Gatos, Calif.-based Starker Services and an FEA board member. In fact, the FEA created a new Certified Exchange Specialist (CES) designation less than a year ago to cater to the growing throng.
The 1031 is no longer just a rich man's domain. "The vast majority of exchanges throughout this country - about 90% - are done by John Q. Public," Kuns says. "You see them selling a rental home in Schenectady and rolling it over into a four-plex."
Depending on the complexity of the transaction, accommodators can be reasonably accommodating in price, charging anywhere from $250 to $3,000 for simple transactions to between $8,000 and $13,000 for complicated deals, says Ponticiello of Jones Lang LaSalle.
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