1031 exchanges yield income

1031 exchanges yield income, write-offs
Market for exchanges grew to $4 billion in 2007, from $200 million in 2001
By Richard Price February 11, 2008
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The strategy of swapping investment properties is similar to the dreaded Yankee gift swaps, in which everyone buys a holiday present for someone else and then, in a lottery style face off, swaps it for something more desirable.
In essence, participants hope to walk off with the cool iPod accessories and not get stuck with the hand-knitted tea cozy.
In the world of swapping properties, the idea is for advisers to send home clients with a Class A property with great cash flow, not the real estate version of the tea cozy.
When an investor trades an apartment house for a new and hopefully improved building, the transaction is classified as a Section 1031 tax-deferred exchange under Internal Revenue Service rules.
The market for exchanges has grown to more than $4 billion in 2007, from $200 million per year in 2001, said Jeff Hanson, chief investment officer at Triple Net Properties LLC, a Santa Ana, Calif.-based provider of tenant-in-common programs.
Tenancy in common is an interest in property between two or more people. But in a new twist to the old deal, clients can opt for a tenant- in-common fractional-ownership approach, which allows them to choose from among high-rise office buildings, apartment complexes and retail strip malls.
Under this arrangement, the client is a partial owner with other investors in the building and receives depreciation write-offs. In these deals, the IRS caps the number of investors at 35.
For instance, Don Ingram, an independent adviser at Ingram Financial Group Inc. in Winter Haven, Fla., is a 1031 specialist.
He helped a client sell his citrus grove business and reinvest in an apartment building complex in North Carolina. The deal generates cash flow of 6.5% but without the responsibilities of owning a grove.
Investors in 1031 exchanges are generally at least 60 years old, are seasoned investment property owners, and they plan to hold the deed on the property until it passes to their heirs, said Brent Barnes, who has many clients in tenant-in-common investment programs and runs a tax advisory business near Nashville, Tenn. "At that point, the surviving children get a step-up in the cost basis," he said.
Both Mr. Ingram and Mr. Barnes work at finding suitable prospects for 1031 exchanges. For instance, Mr. Ingram's partner and independent adviser, Nick Toadvine, is an active member of the Florida Citrus Association in Orlando. Mr. Barnes relies on his tax advisory business to identify clients who own investment property.
If you are considering helping clients exchange their properties, here are some pointers:
• Only investment properties, not personal residences, can qualify. "Look at the tax returns filed every year," said Randy Beckman, senior vice president at Triple Net Properties. "The returns should say they are marked as investment properties." But when in doubt, check with a certified public accountant.
• The swap must be for a similar type of investment, also referred to as a like-kind exchange.
• After the sale of a property, investors have 180 days to land a new one. The IRS rules are clear: Beginning the day after a sale closes on an existing property, a client has 45 days to choose a replacement property and then close on it within 180 days.
Neither weekends nor legal holidays stretch out the time period, Mr. Beckman said. He recommends earmarking up to three properties — even if they plan to roll into only one — to hedge their bets in case the first and second choices do not work out.
• Hire a middleman to help with the execution. In fact, you'll need to hire three of them. An exchange that doesn't raise the IRS' eyebrow will require the help of a certified public accountant, a real estate attorney and a qualified intermediary, a specialized escrow agent. The intermediary holds the funds from the property that was sold until a new property is bought.
Hiring an accountant or an attorney as an intermediary jeopardizes the integrity of the transaction. But as anyone who has closed on a house knows, there are many papers to file and sign, so the scrutiny of a CPA and an attorney will ensure that the exchange will go well.
• Choose proficient clients who have investment real estate experience and have enough investible assets to make the strategy viable. For instance, Mr. Ingram selects clients who have a minimum of $1 million of investible assets and at least $200,000 for the tenant-in-common program.
Richard Price is a senior research analyst for Investors Capital Corp. of Lynnfield, Mass. He can be reached at rprice@investorscapital .com.