Non-Traditional Options for the Exchanger

Capital Gains tax rates vary over time just as our income tax rates vary year-to-year.  At the whim of Congress, our tax rates can increase and are oft times scheduled to increase.  With the Bush tax cuts on Capital Gains scheduled to sunset in 2009, returning our capital gains tax rates in 2010 to the 2000 mark of 20%, investors are more aware than ever of the need to complete a 1031 Exchange as they reposition their real estate investments and are looking for options of how to reinvest in properties that meet their lifestyle goals while not sacrificing the equities they have build up as properties have appreciated over the last 5+ years.

With all of the options the world has to offer, shouldn't real estate investors also have options when trying to defer capital gains taxes?  I think so - and incidentally, so does the I.R.S..  § 1031 was written in 1921 to allow farmers to directly swap lands as the geography changed with season.  The code remains relatively unchanged and continues to provide that:

"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 a like-kind which is to be held either for productive use in a trade or business or for investment."

SO, what does like-kind really mean? 

Like-kind, in the Real Estate world simply means investment or business real estate for other investment or business real estate. 

So, how many choices are there?

MANY - in addition to the standard single family home, multi-family, commercial, retail, industrial, hospitality, and raw land options, there are others gaining popularity despite the fact that few real estate agents sell them.   The below options include Tenants-in-Common (TIC) interests and both working and royalty interests in Oil and Gas.  While these options are not top-of-mind for most agents, they do often meet the demands of an ever changing investor profile.  Each may be a valid 1031 Exchange option for investors which REALTORS® should be aware of them.

Tenants in Common (TICs) - This Billion dollar + industry is essentially five years old.  Blossoming with the issuance of IRS Rev Proc 2002-22, which acknowledged and approved a Tenancy in Common investment as like-kind replacement property, the TIC industry has continued to grow and is thriving today.  Tenants- in- Common interests are sold by licensed Securities Brokers - not real estate agents (unless they are dually licensed).  Recently, the National Association of REALTORS®(NAR) petitioned the Securities and Exchange Commission(SEC) to allow experienced real estate agents to be compensated for their involvement in TIC transactions.  NAR defines an experienced REALTOR® as one who has received a CCIM, SIOR, ACL or has sufficient transactional experience to equal the above.  No solution has been announced as of this article but one is expected shortly.

Here's how a TIC works:  a Sponsor company buys institutional grade investment property and secures financing for Tenant in Common purchasers.  They then go through a legal process preparing a private placement memorandum in compliance with the S.E.C. and then offer the property, via certain Securities Brokers, for sale in undivided fractional interests to accredited investors.  Each investor has a minimum investment amount as the SEC allows a maximum of 35 investors per property.

At minimum, an accredited investor is an individual or married couple with a Net Worth exceeding $1M or an annual income for the previous two years of $200,000 if single or $300,000 annually if married.    The industry is made up of investments of varying property types across the entire nation and draws over a billion dollars of real estate equity each year - most often from property sold as part of a 1031 Exchange.

Investors purchase an undivided interest in a specific piece of real estate and typically receive a deeded property interest.  Owners of TICs receive their proportional share of the rental income and are able to depreciate their share of the asset.  Types of properties purchased as a TIC vary.  The majority of purchases in 2007 were in Office and Apartment however in past years, retail properties have taken a lead. 

Benefits of TIC properties to investors include:  1) Hands-off investment backed by a real estate asset 2) The ability to 1031 exchange into a passive investment 3) Returns from larger properties without the capital requirement. 

Nothing is perfect, and there are some negatives as well, which may include:  1) Mandatory financing which may make it difficult to buy non-TIC replacement properties after the property is sold.  2) The illiquidity of the investment makes it difficult for investors to sell their fractional interest prior to the entire property selling.  3) Securities Brokers are not real estate agents and the due diligence and returns quoted may not be what an experienced real estate investor is accustomed to seeing. 

All things considered, there are securities brokers who have made TIC sales their primary business and have experience with hundreds of properties and have seen them go full cycle.  Also, some real estate agents have found it lucrative to become dually licensed and have the experience analyzing investment properties required to assist investors to make informed and educated decisions about their investments.   

Oil and Gas - The rise of oil and gas as like-kind replacement properties really started to grow post 2002-22 as well;  Not because of any new guidelines for this industry (the I.R.S. has allowed real estate like-kind-exchanges into both working and royalty interests pre - 2002), but more so because of two factors.  1)  The very hot real estate market that made finding suitable replacement properties difficult if not impossible.  2) The securities brokers increased awareness of the need to help 1031 real estate investors find replacement properties.  Statistics about the quantity of equities flowing into this industry are difficult to confirm.   Estimates indicate that "oil and gas interests sold through the TIC distribution channel now appear to total several hundred million dollars annually" (Stephen I. Burr -Foley & Lardner LLP, Tenant-in-Common Legal News November 2006).  This somewhat less mentioned replacement property option is appealing to investors because of the simplicity of the transaction, low minimum investment requirements, full-cash purchase without leveraging, diversification, passive income and the ability to resale in an established secondary market.  In addition, the tax benefits, not only of completing a 1031 exchange into this like-kind replacement property, but also depletion and depreciation of intangible drilling costs (i.d.c's), may be enticing to investors.

Price Volatility is of great concern to the Oil and Gas Industry.  As the price per barrel of US oil increases, returns to investors increase.  The same applies to declining prices. Unlike with the real estate market that provides indicators of changing market conditions, the oil and gas industry can be affected by unpredictable events such as hurricanes, wars, insurrections, technology advances and pollution concerns.  In commercial real estate, properties often have an alternate use should demand for a specific tenant evaporate.  With oil and gas, there is no alternate use.  Depletion and decline of production from a well can significantly impact an investor's return, as can operational risks due to drilling activities with a working interest.  Sponsors of these interests do not always have a long history and securities brokers with little knowledge of how to evaluate such investments make it difficult to assess the risk associated.

Understanding more like-kind replacement options can make real estate brokers counsel more relevant and valuable to his/her clients.  Once an agreement between the SEC and NAR is reached, we will see some securities firms begin to offer referral fees or consulting fees to real estate agents who help direct their accredited sellers to the broker and help evaluate the TIC as replacement property for their 1031 exchange.    

The Baby-boomer generation is retiring, Gen X'ers are having families, and lives change with the passing of days.  A 1031 Exchange allows investors to transfer equity which does not fit their lifestyle and goals to an asset which meets their current and future needs.

 Amy Gustin, CES® is a Qualified Intermediary with 1031 Exchange Coordinators.  She facilitates hundreds of exchanges each year including reverse and improvement exchanges.  She serves on the Board of the Snohomish County Camano Association of REALTORS®, is a member of the WA State CCIM Chapter and is actively engaged teaching continuing education with Washington REALTORS®.   Amy may be reached at 800-320.1031 or amy@1031eci.com.