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Page 14 — Multifamily Properties Quarterly — November 2016
M ost market participants are
familiar with the concept
of a like-kind exchange
pursuant to IRC Section
1031. In a Section 1031
exchange, an investor may defer
income taxation of the realized gain
on the sale of a property by invest-
ing in a replacement property. There
are numerous eligibility, identifica-
tion and timing restrictions with
which exchanges must comply – but
careful planning and coordination
can result in a smooth process and
effective results. This article exam-
ines an example of how an investor
can achieve a significant portfolio
transformation using a lesser-known
capability within the Section 1031
exchange regulations.
The investor owned an apartment
building project in an adjacent state
for many years. Based on its strong
cash flow, the apartment building
project has a current valuation of $8
million, with net debt of $3 million.
The investor’s goal is to reduce the
geographic portfolio footprint in order
to make its operations more efficient;
the plan is to execute a Section 1031
delayed exchange.
In a Section 1031 delayed exchange,
the property intended for sale is the
relinquished property. The property
to be purchased is the replacement
property. The investor engages a
qualified intermediary (in this case,
1031 Corp in Pennsylvania, a highly
experienced 1031 exchange specialty
firm) to conduct the exchange. (See
illustration.)
In a Section 1031 exchange, it is
critical that the investor receives no
cash or property other than a like-
kind replacement property. Therefore,
in a Section 1031
delayed exchange,
the proceeds of the
sale of the relin-
quished property go
directly to the quali-
fied intermediary.
The qualified inter-
mediary then uses
the proceeds as part
of the funding to
acquire the replace-
ment property
within the 180-day
period.
Now let’s assume the investor
locates a purchaser for the apart-
ment building project for $10 mil-
lion. As part of its §1031 express loan
program, we (the bank) provide a
loan commitment to the proposed
purchaser with a 180-day closing win-
dow, thus assuring the seller both the
proceeds of the sale and the timing
of the sale for Section 1031 exchange
purposes.
Even before the investor begins
negotiating the sale of the existing
apartment building, the investor
scours the local market for reinvest-
ment opportunities. The process of
identification is crucial to Section
1031 exchanges because of the 45-day
rule, wherein an investor must iden-
tify all of the potential replacement
properties in the exchange within 45
days of the transfer of the existing
property. Failure to meet all of the
requirements of the 45-day rule can
void the exchange.
The investor determines that own-
ers of a large apartment project in
town may have an interest in sell-
ing for $18 million. During the initial
research, the investor determines
that the project is actually 11 separate
buildings (both by property address
and tax identification number) in two
different planned unit development
tracts, all with common ownership.
The potential sellers indicate that, for
management reasons, they want to
sell the entire project at once.
A common method to satisfy the
45-day rule is to identify up to three
properties as the replacement proper-
ties (“three-property limit”) by written
notification to the qualified interme-
diary. If the investor actually closes on
any of the three identified properties
within the 180-day closing window,
the 45-day rule is satisfied. Clearly,
the target project exceeds the three-
property limit.
A lesser-known method to comply
with the 45-day rule is the “200 per-
cent limit” for replacement property
identification. An investor can iden-
tify an unlimited number of replace-
ment properties, so long as the total
market value of the identified proper-
ties does not exceed 200 percent of
the sales price of the existing prop-
erty. The “200 percent limit” provides
the additional flexibility necessary
to properly identify replacement
property for an effective Section 1031
exchange.
Once the investor identifies the
replacement properties under the
200 percent limit, we conduct due
diligence and are ready to issue
loan commitments to purchase the
replacement properties. At this point,
the investor is prepared to execute
contracts to sell the existing project
and purchase the replacement proj-
ect. Using §1031 Express, we coordi-
nate the closings with the qualified
intermediary to meet the Section
1031 time limits.s
Mindy Koehnen
Vice president,
BankFinancial,
Denver
Lending
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BankFinancial
A flow chart of a Section 1031 exchange, with BankFinancial representing the bank.