COVER STORY, MARCH 2005

When it comes to trends in the real estate industry, one of the hottest buzz terms in Texas is “1031 Tax Deferred Exchange.” Although this tremendous tax benefit has been available to real estate investors since 1921, recent market conditions have sparked an unprecedented growth in the number of investors taking advantage of 1031 exchanges and their tax benefits.

The current market conditions are driving demand for 1031 exchanges. With interest rates remaining relatively low and investor confidence continuing to keep money flowing toward real estate instead of more volatile investments, real estate owners continue to receive unprecedented offers on for-sale investment properties.

Millions of real estate investment dollars are flowing into Texas through 1031 exchanges from all across the country. Investors in states where real estate prices remain inflated are finding a significant improvement in their investment performance by selling properties and taking advantage of the 1031 exchange process to purchase new assets in Texas, where investment performance is more favorable.

“Most capital coming to Texas for investment properties is from California or other states. Exchange buyers selling in California find Texas investments extremely attractive. Texas investments typically provide better returns and lower risk, plus Texas has no state income tax. Most investors are leveraging into larger or better quality assets. As long as Texas investments maintain this gap, exchange buyers will  keep the Texas market competitive,” says Brad Bailey, sales manager for Marcus & Millichap’s Austin and San Antonio offices.

This calculation shows that a significant amount of investors’ proceeds from the sale of real estate is owed to the IRS at the end of the year if they do not take advantage of a 1031 exchange.

For investors planning to sell existing assets and reinvest their proceeds into future acquisitions, the 1031 exchange has become a necessary component of the transaction. Upon the sale of any asset held for investment, taxes are owed in the year of sale. These taxes include both 15 percent long-term capital gains taxes and a recapture of depreciation taken at a rate of 25 percent.

In Texas, many investors have historically chosen not to take advantage of 1031 exchange benefits because they believe that the exchange is difficult and time consuming. In reality, the exchange is quite simple.

The first step in setting up an exchange is to hire a Qualified Intermediary (QI). Investors should look for a company that is reputable and financially sound. Tax advisors and escrow officers can assist in this hiring process. Once the earnest money contract is signed, the QI will contact the escrow officer who will be able to provide all of the necessary information for setting up the exchange. The exchange paperwork is signed at closing by the taxpayer and the exchange begins.

From the date of closing for the relinquished property, the taxpayer has 45 days to identify like-kind replacement property and 180 days to acquire title to the new asset. This 45-day time period is considered by many to be the most difficult part of the exchange process. One common misconception involved with the exchange is the definition of like-kind property. When it comes to real estate, this definition is very broad and can be any type of real estate as long as it is to be held for investment or the productive use in a trade or business. Raw land can be sold and improved property purchased and vice versa. Also, an investor can sell an apartment complex and purchase retail or industrial. The 1031 does not restrict property types or asset classes.

For an investor planning to sell property and purchase a new real estate investment, the exchange will prove an invaluable tool by allowing the investor to leverage the money owed in taxes to purchase new real estate. For many Texas investors, the entry of out of state investors into the marketplace has made the 1031 exchange a necessary tool to compete.

Noel Hara is Vice President of LandAmerica 1031 Exchange Services in Houston.


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