Investment Analysis

Contract Exchanges

Investors in hot condo markets are trying a complex 1031 strategy.

In specific markets such as California, New York City, South Florida, Las Vegas, and Phoenix, condominiums are the hottest investments. Many investors are looking for creative 1031 transaction structures to cash in on these booming commercial real estate markets. One strategy that is gaining traction among some industry professionals in these select areas is exchanging preconstruction condominium contracts.

Deal Requirements

As with all 1031 exchanges, certain common-sense rules apply to transactions involving preconstruction condominium contracts. These include holding the contract to be sold for at least one year, using a qualified intermediary to handle the details, applying all the initial contract proceeds toward the replacement contract purchase, and purchasing or entering into replacement contracts of at least as much value as the sold contracts.

However, if structured correctly, this little-used exchange strategy can create ample new opportunities for commercial real estate professionals and their clients. The principles are best explained in the Starker v. United States [602 F.2d 1341 (9th Cir. 1979)] description of what now commonly is referred to as the "bundle of rights." As the court ruled in Starker, "title to real property, like a contract right to purchase real property, is nothing more than a bundle of potential causes of action: for trespass, to quiet title, for interference with quiet enjoyment, and so on." Furthermore, the U.S. Tax Court ruled, "(t)he bundle of rights associated with ownership are obviously not excluded from Section 1031" [79-2 U.S.T.C. 9541 44 AFTR 2d 79-5525 (1979)]. In essence, these rulings established the right to exchange a contract for something that already is completed.

The rulings also raise two questions that investors must consider when exchanging contracts. First, can investors exchange a bundle of rights (in this case something uncompleted) for something that is completed (a contract for purchase on unfinished or uncompleted property)? Second, can investors exchange something that is uncompleted for something else that is uncompleted? The answer to both questions is yes.

In addition, both issues also possess characteristics similar to transactions involving options. For instance, if an option is defined as a right to buy something under certain terms in the future, a seller cannot be taxed until the expiration or exercise of the option by the buyer.

The same principle applies to real estate. In Revenue Ruling 84-121 [1984-2 C.B. 168, 1984-33 I.R.B. 4], the Internal Revenue Service determined that an option is a bundle of rights and, as such, could be used to conduct an exchange for property already in existence. This ruling, in conjunction with the Starker case, gives rise to the argument that a bundle of rights under an existing contract of a piece of property that is not completed can be exchanged for a piece of property that already has been completed. (In this context completed refers to developed, constructed, or finished.) These rulings make it easier for qualified intermediaries to take the position that "contract for contract" is a valid like-kind exchange.

Caveats to Consider

While the implications for commercial real estate investors are immense, investors should enter into preconstruction condominium contract exchanges with caution for several reasons. Primarily, investors should bear in mind that the condominium developer's approval generally is required in order to sell a preconstruction contract. And, as a condition of approval, many developers require a share of the sale's profits. In addition, many lenders and financial institutions frown upon on numerous assignment contracts and prefer to see actual contract buyers.

The conservative and safe approach to using Section 1031 for preconstruction condominium exchanges is to obtain a tax opinion letter from a certified public accountant stating that the contract-for-contract exchange qualifies. Investors must be careful since, if the transaction is not handled appropriately, the IRS may raise a red flag if it suspects the contracts being exchanged are for flipping, not investing.

There are clear differences between contract exchange transactions and flipping options. For instance, suppose an investor puts down a $200,000 deposit on a $1 million condominium unit to be completed in the future. The unit is going to be used as an investment, and the owner/investor intends to lease it out for $6,500 a month when it is completed, representing a 6.5 percent gross return on the investment.

Three months prior to the unit's completion, which for the purposes of this example is 2.5 years later, the investor receives a $1.5 million purchase offer for the unit. Selling the contract for that amount grosses a $500,000 profit. He decides to place the $700,000 he received - his original deposit plus the profit - as a deposit on another to-be-built unit with a purchase price of $3 million.

Using Section 1031, the investor deferred taxes on the $500,000 profit because his intent was to use the unit as an investment. He also held the unit for 2.5 years, thereby avoiding the rapid buy/sell pace the IRS generally associates with flipping investments.

Or, to apply the form over substance test, the IRS generally examines an investor's intent. If, for example, an investor conducts exchanges soon after the one-year-and-one-day holding period, which qualifies for long-term capital gains, the IRS, which prefers that investors hold on to properties for at least 24 months, may begin to suspect that the investor is really a dealer. In this instance, a dealer is defined as a taxpayer who makes a living from his or her investments, which therefore are taxed as ordinary income on all profits received.

This definition is crucial, as the consequences surpass losing capital gains tax deferral. The IRS taxes any sale profits that dealers gain as ordinary income. In some states, such as New York, property sales taxes range up to 30 percent. If the IRS finds a taxpayer to be afoul of Section 1031's intent, it has the power to levy an additional penalty on the profit.

When attempting to navigate the path that leads to successful 1031 exchanges for pre-construction condominium contracts, commercial real estate professionals and investors should seek legal and tax counsel on their transactions. In addition, exchangers should hire a well-experienced, independent qualified intermediary to ensure their 1031 transactions are managed according to IRS guidelines.

Stephen A. Wayner, JD, CES

Stephen A. Wayner, JD, CES, is first vice president of Bayview Financial Exchange Services LLC, a qualified intermediary based in Coral Gables, Fla. Contact him at (866) 903-1031 or swayner@bayview1031.com.

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