Real Estate Is Churning: What You Need to Know About 1031 Exchanges

Physician's Money Digest, November 2006, Volume 13, Issue 11

The use of 1031 exchanges allows physicians to defercapital gains taxes on the appreciated value of business orinvestment real estate by exchanging for other properties.1031 tenants-in-common (TIC) structures offer passiveinvestors a way to buy interests in larger properties—oftenanchored by major corporations, retailers, or developers—previously the domain of large institutional investors. 1031TICs provide long-term income, without the problems ofactive property management; these are attractive benefits forphysicians nearing retirement.

The compelling tax advantages are not without pitfallshowever, including invalidation by the IRS. The transactionis complex with specific requirements and procedures thatmust be followed to the letter. There are many ways a 1031can be disallowed, and time limits often prevent salvagingthe tax benefits of the exchange. A financial advisor experiencedwith 1031 exchanges is advisable.

Avoiding Common Mistakes

Steven Crawford, a Certified Financial Planner™andpresident of The Main Street Group in Glen Allen, Va, notesthat 1031 errors typically take place because of qualifiedintermediary (QI) or private placement memorandum misunderstandingsand missed deadlines. The following are themost common areas in which errors involving 1031exchanges occur:

Qualified intermediary. A 1031 property exchangerequires a QI to hold the funds from the saleof a current property until a replacement property ispurchased. According to the IRS, the QI cannot bethe physician's financial advisor, CPA, or any advisoror agent directly involved in the transaction or representingany of the parties. Exchange intermediariesprobably represent the safest alternative, because theyare experienced, licensed, and bonded for millions ofdollars in liability coverage. If one of their people fleeswith funds, the insurance carrier replaces the loss.

Private placement memorandum. Advisorscannot discuss a TIC with an investor before:

  • Filling out investor profiles from both the broker/dealer and the property sponsor;
  • Providing a private placement memorandum(PPM) describing the proposed replacement property.

The PPM is a lengthy disclosure booklet from thesponsor, describing the property, fees, risks, andother vital information.

Real Estate Weekly

Missed deadlines. Investors have 45 days fromthe sale of a property to identify potential replacementproperties and 180 days to close on a replacementpurchase. That sounds simple enough, but itoften becomes a race against the clock. Finding theright type and size property can be daunting. Writingin , Joseph Darby estimates "over200,000 real estate transactions are structured to bea like-kind exchange, and estimates are that well over$100 billion [worth] of these anticipated exchangesfail because of the inability to find acceptablereplacement property."

Given the dire consequences of missing either the45-day identification or 180-day replacement deadlines,physicians doing a 1031 exchange transactionshould identify more than one TIC property as asafety valve in the case that the original property dealfalls through.

Matching Physicians with Property

TIC candidates include accredited physician-investorswith highly appreciated property or propertythat is no longer generating a satisfactoryincome. Crawford recently completed a $3.5-millionTIC transaction for a physician to dispose of afarm only generating enough income to pay propertytaxes. The TIC will generate 6% annual incomefor the physician with no further propertymanagement concerns, and the investment is noless liquid than was the farm.

Replacement properties can include residential,commercial, or industrial properties, including officebuildings, shopping centers, manufacturing plants,apartment buildings, restaurants, senior living facilities,and others.

Crawford remembers an offering his firm receivedfrom a real estate sponsor: a stand-alone buildingoccupied by a major pharmacy available in a $1.5-million TIC offering. "There was great appeal forour physician-investors—the ability to own theirown building with a national pharmacy chain tenantand an advantageous 20-year lease," Crawford says."But the downside was, what could a doctor do withthe building if the pharmacy broke its lease? Locatedon the corner of an intersection—where a gas stationmight logically be—this was not a property thatcould be easily converted into a viable enterprise.Certainly a gas station was not an option. So wedecided not to recommend the property to ourinvestors." It was too big of a risk.

Another property Crawford decided not to recommendwas an aircraft factory leased to a defense contractor,saying "It was a beautiful and highly functionalfacility with a great tenant, but who wouldlease it if the contractor left?" Physician-investorsand their advisors should evaluate TIC properties asinvestments first and a tax strategy second.

Physicians who may need their funds before theestimated liquidation of the TIC property may bebetter off paying the capital gains tax. There's noguarantee when a property will sell and no vigoroussecondary market. If a benefits analysis reveals thenumbers are close between paying the taxes anddoing the TIC, the more prudent choice may be forthe physician to pay the capital gains. "The TICoption should be overwhelmingly supported by thenumbers," Crawford notes. "A TIC should move thephysician into a better investment position, not merelyan alternative. Sometimes, advisors and investorsget so focused on saving taxes they forget that, firstand foremost, this is an investment; it must stand onits own. In any TIC transaction, it's advisable forphysicians to ask themselves if they would buy theproperty if there were no tax issues involved. If not,it's best to look for another property."

Considering Estate Advantages

Heirs receiving the TIC shares of a deceased physicianreceive significant advantages: no capital gainstaxes and a stepped-up cost basis (ie, the value of theproperty at the time of the physician's death) forfuture tax purposes. The benefit would be lost shouldthe TIC shares be gifted to heirs while the doctor wasalive, as the original cost basis would be passed on tothe recipients.

Is the cost of a professional advisor justified in a1031 TIC exchange? Crawford says in addition tothe average 6% annual dividend from the new property,physicians receive due diligence on the property,a properly set up limited liability company structure,necessary legal work, property management, and thereassurance that the transaction will stand up to IRSchallenges. In the case of a $1-million property, the6% annual income on the $150,000 that would havebeen surrendered to capital gains taxes amounts to$9000 a year. If the property is held for 10 years,that's $90,000 in addition to income a physicianwould have surrendered.

Crawford advises physicians to beware of TICofferings with excessive loads of 25% or higher,which are charged by some sponsors, adding "Rarelycan fees of that size be justified by any property orterms." Crawford suggests that physician-investorsconsidering a 1031 TIC property exchange, "have along-term investment horizon and understand thatyou are unlikely to have access to your money untilthe investment property is sold, typically 5 to 10years or more. Choose an experienced advisor withaccess to a large inventory of replacement propertiesfor backup purposes. Evaluate whether the cost of a1031 TIC is justified by the resulting capital gains taxsavings and ancillary benefits.