CREJ - Multifamily Properties Quarterly - November 2016
Most 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 investing in a replacement property. There are numerous eligibility, identification and timing restrictions with which exchanges must comply – but careful planning and coordination can result in a smooth process and effective results. This article examines 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 relinquished property go directly to the qualified intermediary. The qualified intermediary then uses the proceeds as part of the funding to acquire the replacement property within the 180-day period. Now let’s assume the investor locates a purchaser for the apartment building project for $10 million. As part of its §1031 express loan program, we (the bank) provide a loan commitment to the proposed purchaser with a 180-day closing window, 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 reinvestment opportunities. The process of identification is crucial to Section 1031 exchanges because of the 45-day rule, wherein an investor must identify 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 owners of a large apartment project in town may have an interest in selling 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 properties (“three-property limit”) by written notification to the qualified intermediary. 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 percent limit” for replacement property identification. An investor can identify an unlimited number of replacement properties, so long as the total market value of the identified properties does not exceed 200 percent of the sales price of the existing property. 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 project. Using §1031 Express, we coordinate the closings with the qualified intermediary to meet the Section 1031 time limits.