Find Opportunities for 1031 Exchanges in Today’s Market
25 May 2023 | 10 min read
Reprinted from REALTOR® Magazine by permission of the National Association of REALTORS®. Copyright 2023. All rights reserved.
Reading news reports about the state of the real estate market in the U.S., investors might well decide to wait out the market turmoil, particularly as it relates to pondering financing options. For investors with cash and a long-term outlook, though, this may be an optimal time to use the Sec. 1031 tax-deferred exchange to reposition their portfolio.
First, let’s put the question of investment strategy aside and review how we got to where we are today.
The Last Credit Crunch
You may remember the last time credit for real estate transactions dried up. After the 2007 financial crisis, the lending market stalled while lenders assessed their real estate loan portfolios and recalibrated underwriting procedures and policies. The policies that evolved during that time, due to drastic action by the federal government to spur spending and deter an even bigger recession, included unprecedented reductions in the federal funds rate. Known as quantitative easing (QE), those actions increased investment in the broader economy and in real estate assets. The Federal Reserve’s purchases of Treasury bonds flooded the economy with cash needed to keep the U.S. economy humming.
In the last quarter of 2013, the Fed started to ease off on its QE program and decided to reduce its holdings in Treasury securities. By October 2014, after reaching $4.5 trillion in assets, the Fed halted those purchases. In early 2020, due to the COVID-19 pandemic, the Federal Reserve again initiated QE to stabilize the disruption in the monetary and supply chain markets. The use of QE measures during the early stages of pandemic, together with low supply and high demand, led the real estate market to surge in almost every region and for almost every type of real estate. With the U.S. economy stabilized by the end of the first quarter of 2022, the Fed completed a final round of Treasuries purchases. By that time, QE purchases had reached $6 trillion.
Inflationary and Recessionary Cycles
The expression “what goes up, must come down” addresses the circumstances the U.S. found itself in after QE stopped. QE measures, used over a long period, eventually contribute to market inflation and rising interest rates. A number of other factors over the past year—among them, the war in Ukraine leading to higher energy and food costs, China’s zero-tolerance Covid policies affecting global supply chains, rising wages and labor shortages—contributed inflationary pressure. The Fed rolled out seven rate hikes in 2022 alone to stave off inflation. So far this year, there have been another three increases. The specter of a recession goes hand-in-hand with those rate increases. No doubt, you’ve heard the predictions from financial analysts and pundits.
Once Again, Lending Dries Up
It’s no secret to real estate pros that the market is incredibly sensitive to Federal Reserve actions. So in the second half of 2022, we witnessed an abrupt slowdown in financing for commercial and residential loans. Now we watch the lending markets daily, perhaps with eyes wide shut in disbelief, to see what the fallout may be from continued hikes.
With inflation moderating, National Association of REALTORS® Chief Economist Lawrence Yun has called on the Fed to halt increases. That’s because a more stable interest rate environment will spur sales and reduce downward pressure on valuations. NAR’s latest home sales data shows that, after the big pandemic-era runup, 31% of metro markets saw home price declines in the first quarter. The downturn has been more pronounced in commercial real estate, primarily because of office space vacancies due to hybrid or remote working policies.
The recent regional bank crisis is not helping, as most commercial real estate loans come from those banks. Some analysts are predicting as much as a 40% decline in real estate values because of the lack of credit and other market forces.
Good News for Bargain Hunters?
Agents and brokers who have been through previous cycles know that slumping prices are an opportunity for investors and borrowers who have stockpiled cash and don’t need bridge, construction, acquisition or other financing. Such buyers are well-positioned to take advantage of the financing and valuation hiccups affecting various sectors of the real estate industry.
Additionally, investors can take advantage of the market by targeting real estate assets that already have land entitlements secured by the relevant governing authorities and that the owner must sell due to liquidity and other refinance deadlines on their existing debt. Our firm is hearing anecdotally on a daily basis that more lenders are accelerating or calling debt due before maturity due to defaults under the loan documents or even foot faults made by borrowers or their guarantors, coinciding with the liquidations of portfolio assets. These are unfortunate circumstances, but they can work to the advantage of long-term opportunistic real estate investors (as opposed to short-term speculators, who will not be able to avail themselves of the solutions discussed in this article for a number of tax reasons). Finding the right buyers in such circumstances can keep the wheels of commerce moving so that the market can recover more quickly, even in the face of an anticipated recession.
Working an Irresistible Acquisition Into a Tax Exchange
For many investors, the 1031 exchange provides the perfect vehicle for repositioning a real property portfolio.
Tax Regulations Sec. 1.1031(a)-3 provides a unifying definition of what assets comprise real property for Section 1031 tax-deferred exchanges. As set forth in the Tax Cuts and Jobs Act of 2017 (TCJA), assets that were formerly classified as “intangible” or “personal” may be like-kind replacement property, giving investors more selections for like-kind replacement property. For example, "land and improvements to land,” which include those that consist of inherently permanent and structural components of land, unsevered natural products of land, and water and air space superjacent to land, are real property. Also, leaseholds, options, easements, and land development rights are real property.
Engaging in an “improvements” or “build-to-suit” reverse exchange may be more viable given declining market prices and continued demand for certain classes of real property assets such as multifamily, industrial, and certain mixed-use properties for logistics, digital infrastructure and flex-work spaces. An investor can either (1) Target and “park” a new real property acquisition that may be undervalued with an exchange accommodation titleholding party (known as an EAT) and use some combination of cash and short-term financing (such as private equity hard money loans or equity from pooled financing credit lines) to loan the funds to the EAT, who would then park the acquisition or replacement property during the 180-day exchange period on behalf of the taxpayer, or (2) Sell a targeted relinquished property using a qualified intermediary and instruct it to provide those funds to the EAT to acquire, park and improve a replacement property based on the 180-day exchange period for the relinquished property. The act of parking a property with the EAT is required so that the taxpayer does not hold title to both the replacement and relinquished properties at the same time.
Making It Work
If you have investor clients seeking to reposition portions of their portfolio and they in fact have real property they’re considering selling, here are factors to consider in making a build-to-suit exchange work.
- Regardless of the structure of a build-to-suit exchange, engage the services of a well-capitalized and reputable qualified exchange intermediary and an EAT. This is critical since most of these companies are not federally supervised and may not be licensed, bonded or insured in the states where they operate.
- Make sure your construction plan during the parking period is detailed and ready to go once the property is parked with the EAT. This means having a budget, plans and specifications, delineated phasing plans and a detailed construction timeline. Understand that costs expended for construction must be those that relate to hard construction, rather than soft construction costs. For that reason, seek out assets where the entitlement process has already occurred or is on the verge of being finalized.
- Due to labor and materials shortages, 180 days is a very short time frame to accomplish a meaningful amount of construction. One of the ways to avoid boot gain is to acquire a replacement property that is equal to or greater than the relinquished property, so whatever construction has been completed by the end of that period will be factored into the replacement property cost.
- Because of the funds being made available from the Infrastructure Investment and Jobs Act, there continues to be stiff competition for construction laborers. Investors with capital may be able to offer higher wages than is available through other private and public sector work. Rising costs of construction for labor and materials may be offset by decreased market prices for real property assets in certain markets.
- Seek out sale-leaseback acquisitions that will allow you to recapitalize a property while the investment earns income. Many national, international and other large companies are divesting their real estate interests but will continue to require the use of those properties under long-term leases.
Any shift in a real property portfolio during uncertain times and under uncontrollable circumstances is going to make investors think twice before spending time and money to structure an improvements exchange. But as a racing fan, I often quote someone I have admired over the years, Mario Andretti, who famously said, “If things seem under control, you are just not going fast enough.”
There is always opportunity in all markets and sectors. Investors who plan or who direct the planning of the composition of real property portfolios with commitment and intentionality are the dreamers and the makers of dreams. They create places, structures, shelters, and life-sustaining systems that are one of the major economic drivers of prosperity in the U.S.