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Shopping Centers Today -> October 2003
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Bush tax cut weighed
1031S STILL HOT, PLAYERS SAY
BY DONNA MITCHELL
In mid-May several firms collaborated to complete the largest ever tenancy-in-common, or TIC, transaction when they pooled about 31 investors to buy the 1.2 million-square-foot Puente Hills Mall, City of Industry, Calif., valued at $148 million.
Such deals are an outgrowth of the 1031 exchange market, which allows investors to avoid capital gains taxes.
About two weeks after the Puente Hills deal, President Bush signed the Jobs Growth and Tax Relief Reconciliation Act of 2003, a major tax-cut initiative that, among other things, reduced federal capital gains taxes from 20 percent to 15 percent. Market players wondered, therefore, if the tax break would undermine the incentive for 1031 exchange deals.
But many involved with the deals say the future for the 1031 model looks strong.
“Capital gains reduction has not done anything to reduce the level of 1031 exchange activity across the country,” said Tim Egan, executive director of the Federation of Exchange Accommodators, a trade association that represents intermediaries. (Intermediaries serve as brokers by holding the proceeds from an original sale and distributing them to the sponsor when the replacement property is purchased.)
Industry executives estimate that the 1031 exchange market has grown by 20 to 30 percent over the past couple of years and that some companies have doubled their business over this period, says one executive who asked to remain anonymous.
And the sector will continue growing, despite the decline in capital gains taxes, says Egan. “A lot of people don’t want to pay that tax — especially on multimillion-dollar transactions, which are somewhat the norm for 1031 exchanges,” he said.
Added in 1921 to the U.S. tax code, 1031 exchanges — named after that section of the law — allow property sellers to defer paying capital gains taxes on a sale if they buy a property of equal value. The seller has 45 days to identify a replacement property and 180 days to actually buy it. And 1031 exchanges do not just involve real estate. Investors have done similar exchanges on such properties as aircraft, rail cars, automobiles, oil and gas equipment and even livestock, says Rob Hannah, president of Tax Strategies Group, a Chicago-based real estate investment firm.
Recent data on completed real estate 1031 exchange deals are hard to come by, because the qualified intermediary occupation is unregulated and few companies track such deals. Further, the Internal Revenue Service rarely publishes its research about the market. But, in a late-2000 survey, Deloitte & Touche estimated that $60 billion worth of 1031 exchange deals involving real estate are completed every year.
The high volume of such deals has been fueled by the strength of the real estate market in general. A lot of property holders have been selling properties to cash in on their increased values, says Bill Winn, COO of Passco Real Estate Enterprises, Santa Ana, Calif., which specializes in buying properties for 1031 exchanges.
“I think we will start to see more and more of that,” said Hannah.
The business got a boost from two rulings issued by the IRS in March and September 2002. The first ruling instructed taxpayers on how to structure TIC deals if they want to qualify for a “private letter” ruling on the transactions. In a private-letter ruling, a taxpayer can ask the IRS for a written opinion about his or her tax liability for a transaction. In the past there was no guidance at all, says Hannah.
The second ruling allows those doing 1031 exchanges to acquire a replacement property before selling the old property.
Another compelling explanation for a strong 1031 exchange market, say professionals, concerns aging baby boomers and their changing priorities. Some, especially those in charge of family trusts that invest in retail real estate, are choosing not to actively manage the properties any more, says Jay Bastian, senior vice president of dispositions at Commercial Net Lease, an Orlando, Fla.-based REIT. Bastian arranges for the sale of triple-net-lease properties. Those clients are looking to sell off high-maintenance properties and buy triple-net-lease properties. In a triple-net-lease deal, the tenant pays rent, insurance and maintenance costs on a property, while the owner simply collects rent checks. Of the $1.2 billion in triple-net-lease property sales that were slated to be completed this past January, about 80 percent were destined for 1031 exchanges, says Bastian, citing a January survey by Commercial Net Lease.
Exceptionally low interest rates, a stock market that is not yet robust and yields that beat the returns of most long-term investments have also come together to create a strong demand for such deals.
Most 1031 exchange professionals say that demand has remained strong because capital gains taxes are often complicated and still onerous, despite the cut. When calculating a seller’s tax obligation from a property sale, accountants start with the property’s sale price and subtract what is called a cost basis — the property’s original purchase price plus any capital improvements, minus depreciation, explains Hannah. Another item, called depreciation recapture, is added to the tally. The amount of depreciation that a seller has claimed on a property throughout his ownership is taxed at about 25 percent. In addition, a property seller might face a state-level capital gains tax, said Hannah.
While most property sellers don’t clearly understand how their real estate taxes are calculated, they do know that they don’t want to pay them, says Bastian.
The Puente Hills deal came about when Krausz Co., a family-owned, San Francisco-based real estate investment firm, sold the property to Passco Real Estate. Faris Lee Investments, Irvine, Calif., brokered the deal.
Passco Real Estate locked in a $96 million loan from Greenwich (Conn.) Capital Financial Products and then assembled the buyers. The investor group had to put up $56 million to secure the loan and buy the mall. Split among the 31 fractional interest holders, Winn says, the investment amount came to about $1.8 million per share.
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