FEATURE ARTICLE, MARCH 2006

RE-INVESTING IN REAL ESTATE
Many investors are benefiting from the IRC 1031 exchange tax code.
Wayne Roitsch

The real estate climate for the utilization of Internal Revenue Code (IRC) 1031 exchange rules in tax planning has been very compelling. In most cases, real estate property investors have been faced with large taxable gains upon the sale of their properties. Many wish to or need to re-invest in real estate as their business needs grow or they decide to shift emphasis from one type of real estate to others. The encroachment of municipalities onto ground previously utilized by agriculture has led this particular group of land owners to re-invest farther away from the growing population surge in order to avoid the problems associated with the denser population. The fallout is the need to preserve as much of the value growth in order to maximize capital for subsequent investment. Deferring some or all of the capital gains tax allows the investor to maximize his or her opportunities.

If properties continue to gain in value under any scenario, the utilization of an IRC 1031 exchange makes a lot of economic sense. Because of the nominal cost for executing an exchange, just about all real estate sales, large and small, are candidates. In fact, if the sale results in potential depreciation recapture, there is more incentive to expedite an exchange. The only negative aspects of the exchange process are the requirements by the IRC to identify replacement property within 45 days of the sale and the need to complete the exchange within 180 days.

Target replacement properties for exchangers tend to vary according to the investment stages of the exchangers. One class of popular replacement property includes triple-net lease buildings rented to tenants with high safety ratings that require no landlord participation other than going to the mailbox and picking up the check. However, this popularity has caused capitalization rates on triple-net lease properties to be relatively low compared to other properties requiring more landlord management. The capitalization rate most often, but not always, reflects the quality of the tenant, quality of the lease and location of the property. The early pressure on capitalization rates was likely the result of a large influx of stock market money moving to investment properties; however, recently expanding amounts of 1031 exchange funds chasing tighter supplies of quality investment property seems to be the norm.

“Downward pressure on cap rates may be diminishing, at least for the moment, but competition for good properties is very intense,” says Brian Collins, broker for Post Office Realty, Inc. Failures for exchangers to locate properties that still offer attractive return and acceptable risk seem to be increasing. Exchangers are having to balance the effect of just paying the taxes on their real estate gain versus closing on a property that doesn't totally comply with their target criteria.

There are significant regional differences in acceptable cap rates, and we see investors from other areas of the country more amenable to investing in Texas markets than some of the homegrown investors. The perception in many cases is that Texas property is a better value than the markets they are abandoning, and, in most cases, this is based on fact. The typical cap rates on the West and East coasts are significantly lower for many types of real estate than in Texas, and this is a powerful incentive to move the money where the payback is the greatest. Considering the sizable gain on most all properties in these areas, it would take a major economic slowdown to stem the tide of 1031 funds. Even at that, the new awareness of the 1031 exchange rules makes almost everyone a player in today's market, large or small. These factors are likely to continue escalating the use of IRC 1031 rules for investors in the years ahead.

So what factors could change the investment real estate market in general and 1031 exchanges specifically? Factors that are always a concern include rising interest rates, changes in capital gain tax rates and general economic slowdown. None of these appear to be an impending concern, but accurate crystal balls are always in short supply.

Wayne Roitsch is a co-owner of New Braunfels, Texas-based The Texas 1031 Exchange Company.

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