Investment Analysis

Exchange Your Strategy

Investors should consider alternatives to 1031 transactions.

An increasing number of today’s commercial real estate investors are knowledgeable about the benefits of exchanging qualified investment real estate under Internal Revenue Code Section 1031. However, they might not realize that 1031 exchanges aren’t ideal for every investor or every investment scenario. Skilled commercial real estate advisers understand that executing an exchange must make financial sense and have a favorable impact on an investor’s short- and long-term goals. In some instances, it may be advantageous to advise clients against utilizing an exchange strategy. Depending upon a client’s goals, other alternatives may offer greater benefits when disposing of commercial investment real estate assets.

Why Consider Alternatives?

Though the disadvantages of cashing out and paying capital gains taxes are obvious, selling investment property can be a wise decision under certain conditions. The following scenarios illustrate reasons why some commercial real estate investors should think twice before executing 1031 exchanges.

No Recognition of Loss. If an investor is disposing of property at a loss — that is, the sale price of the relinquished property is less than its adjusted basis — and the investor wants the loss to be tax deductible, the property must be sold and not exchanged. If the disposition is structured as an exchange instead of a sale, no loss is recognized. Moreover, with a property sale, any loss that is not utilized in the current tax year has an unlimited carry-forward that can be used to offset future income. In an exchange transaction, the investor would not have the option to offset losses against future income.

Availability of Capital Loss Carry-Forward. Excess capital losses from prior years may be carried forward for an unlimited period and may be used to shield future capital gains from taxation. Thus, a capital gain from the disposition of a property in the current year may be absorbed by capital losses carried forward from prior years, thereby reducing or completely eliminating any tax due upon sale. Consequently, there would be no advantage to exchanging.

Taking Back Purchase-Money Debt. If an investor must take back purchase-money debt when disposing of a relinquished property, the debt may cause a significant portion of the gain to be recognized. Any purchase-money debt the investor takes back as payment for the relinquished property is not considered like-kind property and will result in recognition of gain. This is true even if the purchase-money obligation initially was paid to a qualified intermediary. Of course, the investor has the option to report the gain on an installment basis, allowing the investor to report the gain periodically over the note’s entire term.

Reduction of Basis in Replacement Property. Perhaps the greatest disadvantage of 1031 transactions is that the tax basis of the replacement property received in an exchange is reduced by the amount of gain that is deferred in the property relinquished in the exchange. The result is that the investor has a lower tax basis for calculating the annual depreciation deduction for improvements than if the replacement property was acquired as a straight purchase. However, the advantage of postponing the reporting of the gain and tax payment usually offsets this perceived drawback of an exchange strategy.

Suspended Losses May Not Be Used. If an investor disposes of his entire interest in a property via a tax-deferred exchange, any suspended losses resulting from the passive-loss rules may not be used. Rather, such losses are carried over to the new replacement property. On the other hand, when an investor disposes of his entire interest in a for-sale property, he is entitled to use any losses that have been suspended as a result of the limitations imposed by the passive-loss rules. Thus, under certain circumstances, it may be preferable for the investor to sell his property rather than exchange it if he wants to trigger suspended losses.

If the property is sold, the suspended losses could be used to offset any gain upon sale. This would reduce, or in some cases, eliminate the tax due upon sale. In addition, the tax basis of the replacement property, assuming one was acquired, would be the full cost, with no reduction in the basis for the gain deferred on the relinquished property. The result is a higher depreciation deduction.

Minimal Tax Due. In general, it usually costs more money to complete an exchange than a sale transaction. Thus, an investor should compare the expected transaction costs against the amount of any tax liability that would result in a sale. If the deferred liability is not significantly greater than the expected transaction costs, the investor may conclude that it is not worth the time, effort, and cost of completing an exchange in this situation.

Inherited Property. If an investor inherits investment or business property, the property’s tax basis is stepped up to its fair-market value. Thus, if the investor/heir sells the property immediately at its fair-market value, there is no gain or loss to report. In this case, an exchange would serve no purpose.

Lump Sum Reporting of Income Upon Sale in Subsequent Year. The deferral of gain in an exchange may result in the reporting of previously deferred gain in a single year if the replacement property is subsequently sold. This potential for lump sum reporting of income into a single year may be considered a minor disadvantage of exchanging, since the option to defer the gain and postpone the tax due usually more than offsets this disadvantage. In addition, the problem may be avoided altogether by structuring an installment sale instead of an all-cash sale.

In today’s complex investment climate, commercial real estate professionals can improve their service to clients by investigating a range of possible disposition strategies. While 1031 tax-deferred exchanges offer numerous wealth-building benefits, other disposition alternatives may be worth considering depending upon the investor’s goals and objectives.

Donald J. Valachi, CCIM

Donald J. Valachi, CCIM, CPA, is associate clinical professor of real estate at the University of Southern California. He has been an apartment investor and broker for the past 15 years. Example 1: Granting the Option. Susan buys a two-year option to purchase a small apartment building from John for $500,000. Susan pays John $15,000 for the option. The receipt of the $15,000 option payment has no immediate tax consequences to either Susan (the optionee) or John (the optionor). The receipt of the option consideration is treated as a nontaxable open transaction. The transaction will remain open until Susan either exercises the option or allows it to expire. Example 2: Exercising the Option. Six months later, Susan exercises the option and buys the apartment building for $500,000. Susan\'s tax basis for the property is $515,000 ($500,000 + $15,000). John\'s amount realized from the sale is also $515,000. Example 3: Selling the Option at a Gain. Instead of purchasing the building, after one year, Susan decides to sell the option for $20,000. Since the apartment would have been §1231 property if Susan had acquired it, she reports a §1231 gain of $5,000 ($20,000 - $15,000). Susan\'s sale of the option has no tax consequences for John. Example 4: Selling the Option at a Loss. Assume in Example 3 that Susan sold the option for $10,000 instead of $20,000. Susan reports a §1231 loss of $5,000 ($10,000 - $15,000). Again, the sale has no tax consequences for John. Example 5: The Expired Option. Instead of selling the option, after two years, Susan fails to exercise the option and it expires. Since the apartment would have been §1231 property if Susan had acquired it, the $15,000 forfeited option payment is treated as a §1231 loss. John reports the $15,000 payment as ordinary, taxable income in the year the option expired.

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