A safe harbor alternative to defer income taxes on the sale of a property has been a 1031 deferred exchange. The 1031 deferred exchange has been an excellent way to defer income taxes upon the sale of a property. This form of transaction has been in favor of short or long-term holdings in commercial real estate.
How are 1031 Deferred Exchanges Affecting the Market?
The marketplace for 1031 deferred exchanges has been greatly impacted by Federal Government raising interest rates. The increase in interest rates on home mortgages has increased almost 100% from 3 months ago. Conversely, investors are fleeing the vulnerable stock market for safer investments such as quality triple-net real estate. These so-called pre-packaged commercial triple net real estate investments provide security by having stable returns on long-term leases with little or no maintenance required by the buyer,
The increase in interest rates and the flight from the stock market, an investor is looking for a safe return in real estate, has caused the triple net leased the real estate to pay smaller returns. The CAP rates (actual return to the investor) have been compressed and show much smaller returns than the first quarter of 2022. In some cases, the cap rates have been reduced from 7% to 5% and even less in certain circumstances.
In addition, when “all of the sale funds” coming out of exchange cannot be placed in the exchange property, the investor is confronted with paying income taxes on monies that could not be placed (boot).
How are 1031 Deferred Exchanges Affecting Investors?
Another issue that comes up is when the investor sells the first leg of his investment, which a loan may encumber, the investor must make sure that it obtains a new loan for the same amount or more for the new property.
All partners of the initial investment must be in favor of the exchange or will not qualify under the IRS rules of the exchange (exception if the partnership is in the form of a “tenant in common”). When you have partners in your real estate investment and considering a 1031 exchange, the managing partner must make sure all partners are in favor of moving forward with the new acquisition. If a portion of the investors wants to cash out of the initial investment before the acquisition of the new property, it poses a significant problem.
Since all partners must be in favor of the exchange, what happens if one or two of the existing partners just want to cash out at the sale of the initial property and not be a part of the exchange? Therefore, in this case, other partners or a single partner must buy out the interest of those wishing to exit the partnership. This buyout must be completed prior to the entrance of the exchange. The buyout of the partner becomes complicated by determining the value of their interest in the property. Does the exiting partner receive a diminished value for selling their interest, or does the exiting partner get rewarded by selling their interest? The valuation of the selling partner may become a need for a settlement by means of formal negotiation.
What to Do If a 1031 Deferred Exchange is Affecting You
It is critical that experienced legal counsel should be obtained in addition to an accountant and the services of a qualified intermediary.
Lee Segal, a senior commercial real estate expert, may assist you in navigating the pitfalls or advantages of a 1031 exchange or partnership issues.