RISMEDIA, April 13, 2007-Employing a Section 1031 Exchange to defer taxes in a real estate sale transaction is not a new concept. In fact, the 1031 Exchange has been around for 85 years, ever since its 1921 adoption into the United States Internal Revenue Code. Yet today, more than ever before, private real estate investors are employing its advantages to help grow their portfolios. Why? According to Jeffrey Greenberg and Steven Greenberg, principals of Heritage Management Company in Ridgewood, New Jersey, a number of factors have led to the current surge in 1031 Exchange activity.
In the following Q&A interview, they reflect on this trend:
Q: Why are more companies using the 1031 Exchange today than in the past?
A: Never before has the real estate market generated such strong, rapid appreciation. This, in turn, can mean extraordinary capital gains when a property is sold – even just a year or two after its purchase. As a tax deferment tool, the 1031 Exchange can help investors defer paying capital gains tax. Additionally, real estate tax laws have been simplified in recent years, and while using the 1031 Exchange remains a complex process, it is less intimidating than in the past.
Q: In layman's terms, how does it work?
A: In the simplest terms, it is a "like kind exchange," wherein an investor is changing one asset for another "like kind" asset, which is trading one investment property for another investment property regardless of whether it is in the office, industrial, retail or residential sector.
When investors looking to employ a 1031 Exchange close title on a sale property, they must place the money with a qualified intermediary such as a bank or title company. After the closing, they have 45 days to identify a new property or properties to purchase. They must close on the purchase of one or more of the identified properties within six months of the original property sale closing and must invest the total proceeds from the sale including debt and equity. Of course, tax-deferred is not the same as tax-free. If the replacement property is sold without another exchange, the original deferred gain – and any additional gain – is taxable.
Q: How long has Heritage Management been involved in 1031 Exchanges?
A: We have been taking advantage of the 1031 Exchange for about 20 years and have completed more than 50 transactions involving 1031 Exchange monies.
Q: What is the 1031 Exchange's significance in your investment strategy?
A: The bottom line is that it leaves us with more money to invest. We would not be able to "trade up" and grow our portfolio as quickly as we are without the tax deferral. Small, family-owned companies often own a particular property or properties for many years. If they should sell an asset that has a low taxable basis over time due to capital improvements or other factors, the taxes could wipe them out. As such, many properties owned by private players like us would never be sold without the 1031 Exchange provision.
Q: Can you provide a recent example?
A: Our most recent 1031 Exchange transaction involved two properties in the City of Newark, N.J. In the summer of 2006, we sold 570 Broad Street, a 200,000-square-foot office tower that we had purchased in 2003 and successfully repositioned. We used 1031 Exchange funds from that strategic disposition to acquire Four Gateway Center, a 327,000-square-foot, Class A office tower in Newark.
Q: What does it take to succeed in a 1031 Exchange transaction?
A: You must be willing to "go for it," and fast. Forty-five days is a very short period of time in the real estate world. Once we decide to sell a property, and we have determined that the tax ramifications warrant a 1031 Exchange, we immediately start looking for another asset. Underwriting the potential acquisition, coming to an agreement with the seller and entering into contract all within 45 days can be challenging – and there are no shortcuts. You need to be willing to spend money on due diligence, and you cannot hesitate to move forward. Otherwise, you will miss opportunities. Today, there are companies dedicated to 1031 Exchange consulting. For investors without in-house expertise, they offer a valuable service but at a premium cost.
Q: Are there times when a 1031 Exchange does not make sense?
A: Absolutely. When the capital gains taxes on a sale are relatively low, for whatever reason, a seller may determine that it is less costly – in dollars and time – to simply pay the capital gains. More importantly, sellers should keep in mind that it never makes sense to use 1031 Exchange monies to buy a property that you would not otherwise want to purchase. It is better to pay taxes than purchase a property you do not really want to add to your portfolio. At Heritage Management, we try to keep our options open. Whenever we sell a property, we set ourselves up to do a 1031 Exchange, and we may or may not move forward with it. After all, you never know when you are going to find the perfect investment opportunity.