Local real estate investors who focus on the apartment-building market continue to use tax deferral strategies to complete transactions.
In a $3.9 million deal announced Feb. 8, both the buyer and seller of a multifamily property in Encinitas chose to use some form of a 1031 tax deferred exchange.
Although they have been around for decades, 1031 exchanges and, increasingly, reverse 1031 exchanges, are still popular in San Diego’s multifamily property market, according to anecdotal evidence from some local brokers.
As technical as the name sounds, this financing method, which is named for Section 1031 of the federal tax code that sanctions it, has some straightforward advantages for real estate investors.
Most notably, the strategy allows owners of real estate to first sell their property and then buy other similar property of equal or greater value without paying a capital gains tax.
For this reason, traditional or “forward” 1031 tax deferred exchanges whereby an investor sells a property and then uses the capital to reinvest in a replacement property, within a limited time period became more popular in the late ’90s, according to Ray Adams, a multifamily investment broker at Northbrook, Ill.-based Grubb & Ellis/BRE Commercial’s office in the University Towne Centre area.
According to CoStar Realty Information, Inc., a provider of data to the commercial real estate industry, the percentage of transactions in the apartment-building market in San Diego County that involved 1031 tax deferred exchanges jumped from 32 percent in 1999 to 47 percent in 2000. In 2003, 49 percent of all multifamily property transactions were 1031 exchanges, although the percentage declined during 2004 to 34 percent.
Now a trend has emerged revolving around an alternative tax deferral strategy that such data does not capture.
“Reverse 1031 exchanges have become very popular for those who have the ability to complete them because they remove the risk of finding available replacement property,” Adams said.
Jim Neil, a broker in the investment property sales group at the San Diego office of CB Richard Ellis, agrees. “It is probably more common now to see reverse exchanges in the marketplace,” he said.
A strategy that sounds complicated is really quite simple.
In a reverse exchange, Adams said investors buy before they sell, meaning they must have the capital available to buy a property of equal or greater value to the one they plan to sell.
The benefit is that the investor avoids the burdensome requirement of traditional 1031 exchanges, which force the exchanger to locate a replacement property within 45 days of the sale of the relinquished property, and then close on it within 180 days.
In the tight market that exists now, it is often difficult to locate an acceptable property to buy within this time constraint, according to Adams.
A reverse exchange comes in handy, relieving the exchanger of the burden of finding a new property to purchase right away.
Adams just brokered the $3.9 million sale of the 19-unit Hampton Place Townhouses in Encinitas, in which both the buyer and seller utilized a 1031 exchange to complete the deal. Adams called this an “interesting deal” because the seller, Glenn Goldman Trust, used a reverse 1031 exchange, purchasing a 25-unit apartment building by the beach in Carlsbad, five months before closing on the sale of Hampton Place.
The buyer, Hillcrest BDF Trust c/o Gobar Realty, acquired the property as a replacement property in a traditional exchange.
Adams pointed out that reverse exchanges are popular now for the simple reason that investors are aware of their availability. Also, more “accommodators,” or title companies’ affiliates and attorneys who act as mediators, are open to reverse exchanges , a trend that has become more prevalent only in the past year, he said.
The other restriction on a 1031 exchange is that the exchanger cannot accept money during the transaction, but must instead use an intermediary to hold the proceeds while the exchange is in progress, according to Adams.
Tom Cunningham, who runs the First Federal Bank’s income property lending group in San Diego, said that about two to three months ago he noticed a pickup in requests for lending for reverse exchanges.
Cunningham said that while most banks and savings and loans tend to shy away from lending to these exchangers, he has worked on a few reverse exchange transactions and they are not that complicated.
Increasingly, lenders are realizing this.
“Before, it was difficult to get a loan approved for a reverse exchange because the lender required the investor to have his name on the title. And in a reverse exchange, the accommodator takes title to the property,” Adams said.
But he added that in today’s market, where lenders and buyers are better aware of these types of investment strategies, brokers are seeing them utilized more and more.