Newport Beach businessman Webb Morrow figures he’s swapped real estate properties roughly 25 times in the past two decades,tax free.
Morrow, now in his 70s, has bought and sold apartments, retail space, offices and industrial buildings using what’s known as a 1031 exchange, which stems from a section of the tax code that defers levies on property sales. Some 20 years after his first 1031 exchange deal, Morrow said he’s still putting off paying taxes.
“I keep postponing them as long as I can,” he said
“Some people want to defer until they die,” said Bill Passo, president of Santa Ana-based Passco Real Estate Enterprises Inc., who has helped Morrow and others navigate the money-saving, but sometimes stressful, waters of 1031 exchanges. “The benefit is that if the owner is successful, their heirs never have to pay the income tax.”
The exchange method, also known as a “Starker” exchange, allows property owners to defer capital gains taxes when selling investment and business properties. That is, provided they find a “like-kind” replacement property to put the sale proceeds into.
A like-kind property is broadly defined, encompassing any real estate investment,including vacant land for rental property. The value, equity and debt of the replacement property have to be equal to or greater than the relinquished property.
1031 exchanges are nothing new, but real estate sources say their usage is on the rise these days.
“Right now, in this stage of the economy, you see a lot of people selling older property using the exchange,” said John Kiley, a partner at Silvercreek Properties, a Laguna Hills-based real estate development company specializing in shopping centers. He estimates half of the transactions taking place today are using the exchange, up from about a quarter of the transactions in the past.
Still, a 1031 exchange isn’t for the faint of heart, according to Kiley.
“It is a nervous time,” he said. “It creates some absolute deadlines and a lot of work at the front end to make sure it’s done in a timely manner.”
The 1031 exchange requires buyers find a new property within 45 days and close on escrow within 180 days. Failure to do so disqualifies the property owner from the tax deferment.
To meet deadlines, 1031 clients often turn to hired hands such as Passco Real Estate or any of the many other firms offering help with tax deferment on property deals.
Passo said he has worked on tax-deferred exchanges, in one form or another, since 1974. By 1994, the University of California, Los Angeles law grad and tax attorney by trade said he recognized two things: many investors, especially smaller property owners, were having a tough time finding replacement properties. And most wanted to buy a property they didn’t have to manage.
“Unless the owner was buying something that was $5 million to $10 million, they didn’t have enough gross revenue to have anything left over to buy the kind of property they wanted,” Passo said.
So Passo said he came up with a fractionalized method in which his company locates and buys property, then trades 1031 clients an interest in return for their property assets.
In 1998, Passo purchased Chicago Plaza in Riverside for $8.1 million. He had five investors, four of which were 1031 clients, he said.
“The combined cash was $1.4 million,” Passo said. “Then we formed an LLC with my company as the managing member. The LLC raised $1.3 million.”
As developer and property manager, Passco built a Hollywood Video, leased a pad to Jack in the Box and filled 23,000 square feet of space to another tenant.
In July, Chicago Plaza sold for $11.1 million. The individuals received all of their initial investment back, plus about 15% annualized profit, according to Passo.
“They’re now looking at taking that money and making a new purchase,” Passo said.
Since 1998, Passco’s more than 150 fractionalized deals have generated $60 million in cash equity, he said. The company now manages and controls 2 million square feet of commercial property acquired using the fractionalized structure. The company holds property for three to seven years.
“I would say the bulk of the transactions today involve individuals,” Passo said. “Five to six years ago, it was the REITS. But the REITS have been quiet. Many are even liquidating their property right now.”
According to Silver-creek’s Kiley, a classic example of a 1031 investment is where someone has a management-intensive asset that needs fixing up, redevelopment or might even need to be torn down.
“That’s a great opportunity for them to exchange to a new asset,” Kiley said.
The 1031 exchange is particularly common with shopping centers.
Reza Etedali, a senior vice president with the Irvine office of Sperry Van Ness, said he brokered roughly 20 shopping center deals last year. Nearly two-thirds of them were done with 1031 buyers, according to Etedali. About half took place with investors coming into retail from other investment properties,mobile homes, apartments and office.
With increasing rents and the overall strength of the apartment market, large apartment owners may find it hard to find a similar apartment investment to use as a replacement property, Etedali said. So, many wind up swapping apartments for shopping centers, he said.
“The shopping centers have higher returns and are less management intensive,” Etedali said.
Interest rates and the capitalization rate,a ratio used to estimate the value of income properties,make shopping centers a more logical investment than apartments for now, Passo added.
“You can buy a grocery at 9.5% cap rate and finance at 7.5%,” Passo said. “With an apartment, you buy at 6.5% cap rate and finance at 7.5%. You’re not really making good money. You’ve got a negative cash flow to begin with.”
For sellers, there’s an advantage to working with a 1031 client, according to Etedali.
“Generally, 1031 clients are more motivated to close a deal because there’s an urgency,” he said. “They are also willing to pay a little more because they are saving a significant tax hit.”
Etedali has another theory as to the recent rise in 1031 exchanges, particularly with shopping centers.
“Quite a few investors lost a lot of money and are liquidating their stocks and looking to real estate,” he said. “There’s no more dot-com stuff, so they want something they can touch, feel and see.” n
