Swapping properties: Helping clients succeed in today's commercial real estate market

Managing real estate investments in a down market is a challenge. But savvy real estate professionals know that a down market is when opportunities abound. When the red-hot bull market of real estate overheated, there wasn't time to make considered decisions. Sellers were receiving multiple, over-the-asking-price offers. In a bull market, investors had to be quick, have money, and be a little foolish. Now that the market has cooled down, sellers are considerably more humble and investors can shop for the best deals. In short, this is the time to guide clients on when to hold, fold or...perhaps the best option-"swap." Foreclosures are at a 20 year high and there are many properties on the market. Those in the market suffering the most are the so-called 'flippers' (speculators), the overextended buyers, and those investors who took advantage of the no-money-down offers and 125% financing deals that were plentiful when the market was peaking. Finding these overextended speculators and negotiating deep-discounted transactions is one of the best strategies available in today's market. Many investors find themselves at a crossroads and are faced with three potential choices: 1. Sell quickly and cut losses before they become unmanageable; 2. Employ holding strategies that minimize potential portfolio damage until the market turns up; or 3. Exchange or 'swap' high-risk properties in a 1031 exchange for properties that carry a reduced risk. The third option of exchanging is often the least understood by most investors, but is, in fact, the best strategy for those feeling nervous about their portfolio. History of 1031 Exchanges Section 1031 was introduced into the Internal Revenue Service Code in 1921, which means it has been around for 87 years. Originally, the only exchanges allowed were simultaneous exchanges. In a simultaneous exchange, the seller was required to purchase from the buyer and the buyer was required to purchase from the seller. This made exchanges difficult. Then, in 1923 certain limitations to the non-recognition provisions were enacted which excluded stocks, bonds, notes, trust certificates and other types of securities from the exchange process. No significant changes were made to Section 1031 of the Code until 1984 when time limitations were added. The 45 day rule for identification of properties and the 180 day rule for the purchase of the replacement property were implemented. The real watershed came in 1991. Most tax practitioners are aware that in 1991, the regulations on Section 1031 were defined describing the procedures for deferred exchanges, which is what most taxpayers use today. Since 1991, most tax advisors recommend using Section 1031 for tax-deferral purposes. Exchange Strategies Help a client to look at their properties and ask them a few questions. Do you have multiple properties that have declined in value from their peak, or that you are struggling to finance? Do you own 'high-risk' property such as condominium units, property that has been recently constructed or improved, resort area and vacation area property, or property that has gained substantial value within the last three to five years? Most experts consider these investments as 'high-risk, high-reward' properties. These types of properties are the most volatile -when the market swoons. In fact, they are the properties that are most likely to decline in value, and they generally give back their gains, and then some, very quickly. Exchanging these high-risk properties for low-risk properties is the optimal strategy in a declining market. How do you find low-risk properties in a declining market? I recommend Realtors and brokers help their clients look for the following types of investment property: 1. Commercial properties already under lease with stable tenants. For example, you could join other investors in purchasing a tenancy-in-common interest in a strip mall that has credit-worthy tenants already under a long term lease. A major portion of this type of property's value resides in the steady stream of income flowing from the current operating leases. Using Code Section 1031, the investor could sell the high-risk appreciated property that is currently costing you cash-flow dollars in a tax-deferred transaction, and through a qualified intermediary, purchase replacement property such as the strip-mall that provides a steady income stream. This income stream protects you from downturns in the market by guaranteeing a predictable return on your investment. 2. Foreclosure property. Another option is to sell the high-risk property and go bargain hunting. Under Code Section 1031, you have 45 days from the date that you sell your property to identify your replacement property. The investor will want to conduct research prior to the date of the sale of the relinquished property, and then identify up to three replacement properties of any value. Foreclosure property can be a great deal when thoroughly researched. The investor should also have their own inspector and appraisers examine the property before identifying it as one of the replacement properties. Part 2 will appear in the March 4th edition of the New York Real Estate Journal. Robert Pingeton is a northeastern region business development consultant and Stephen Wayner, Esq., C.E.S., is the first vice president of Bayview 1031, Coral Gables, Fla. 3. Deeply discounted property. Another good idea is to contact agents or brokers to search for properties that have been on the market for an extended period of time, and that have been discounted multiple times in order to sell the property. The sellers of these properties usually will make significant concessions in order to move their properties. Inspect the property since sometimes deep discounts exist for a reason. Exchanging your highly appreciated property for deeply discounted property adds a big margin of safety in a market downturn. 4. Properties in other states. Lastly, if the property is located in Florida, Arizona, Las Vegas, Washington, D. C. or other high-flying markets, the client might consider exchanging into properties located in areas where growth has been steady and modest. These areas will not have seen such dramatic gains, and thus are less likely to suffer significant losses in a market downturn. The goal is to own properties in stable and predictable markets when real estate values are slipping. Using a 1031 exchange can also allow clients to 'tax shop,' and buy properties in markets that have low state income or real estate taxes. This can also keep costs manageable in a down market. Security of Funds with 1031s How does an investment property owner determine if his or her funds will truly be secure during a 1031 exchange? Currently, there are a few popular methods used by QIs to assure complete security. Each has advantages and drawbacks. 1. Segregated accounts. The first level of so-called protection is the establishment of segregated accounts. Instead of co-mingling exchange funds held by the QI, some QIs "segregate" client funds in separate bank accounts. Touted as the ultimate protection, security of funds in segregated accounts is an illusion. Regardless of FDIC protection, segregated accounts do not receive any protection from QI failure, dishonesty or bankruptcy. If a QI files for bankruptcy, each deposit holder in the midst of 1031 exchanges with that QI is classified as an "unsecured creditor" under the U.S. Bankruptcy Code. That is the very bottom rung of priority on the ladder of payouts from the Bankruptcy Trustee. In cases of bankruptcy, unsecured creditors typically receive pennies on the dollar of lost sale proceeds. Indeed, one QI that recently filed for bankruptcy had 'segregated' accounts that did not preserve the investment property sale proceeds (Exchange funds) after the bankruptcy filing. 2. FDIC Insurance. FDIC Insurance - capped at $100,000 - is also publicized as a source of protection for exchange funds. Though FDIC recently raised insurance limits in April, 2006, the new cap applies only to certain types of accounts such as traditional accounts, Roth IRAs and self-directed Keoghs - but not 1031 exchange funds. Also, the $100,000 insurance coverage provided is "per depositor." Most QIs will title accounts in their own name to meet federal rules that restrict investment property owners from having access to Exchange funds. Thus, in cases of malfeasance or bankruptcy, the $100,000 insurance provided by FDIC is shared equally by all for whom the QI is holding Exchange funds at the time that the QI failed to perform. Moreover, there is no guarantee that a QI actually deposits funds from its 1031 Exchanges in a bank. A few QIs have invested exchange funds in risky stocks, derivatives, hedge funds or any other unregulated, uninsured investment vehicles without their clients' knowledge. 3. Too Big to Fail? The next level of protection for the investment property owner doing a 1031 Exchange is to choose a large QI unlikely to file for bankruptcy. Unfortunately, recent failures of mega companies such as Worldcom, Enron, Barings Bank and similar financial miscreants have shaken the public's confidence in such giant enterprises. While some may believe that regulated industries afford a higher level of protection, the S&L crisis of the 1980s revealed a wave of savings and loan institution failures costing taxpayers and depositors approximately $150 billion. 4. Strong Current Ratio. More important than the sheer size of the company is the company's liquidity—the actual amount of cash on the company's balance sheet. That should be compared to its current liabilities to then determine the company's current ratio. A current ratio indicating the company can weather at least six months of expenses before running out of cash is good evidence that exchange funds are fairly safe (especially since 1031 Exchanges must be completed within 180 days). 5. Bonding and Insurance. The ultimate protection for 1031 Exchange proceeds is to use a QI that is "bonded and insured". In assessing the bonding or insurance limits of a QI, there are two important considerations: the amount of the bond or insurance and whether the coverage limits are "aggregate" or "per occurrence". Aggregate bonding or insurance refers to the total amount of coverage for which the insured (the QI) is covered by the policy. For example, if a QI has an aggregate insurance policy for $1,000,000, it means the maximum that the insurance company will cover is $1,000,000 in total losses, regardless of how many clients are involved or how much each client has lost. 6. The Gold Standard. The best coverage a QI can have is a large "per occurrence" policy. Per occurrence coverage provides bonding up to the amount identified for each client in the midst of a 1031 Exchange. Using the prior example, a $1,000,000 per occurrence policy means the QI has $1,000,000 of protection from loss for each client in the midst of a 1031 Exchange. Not many QIs can afford large 'per occurrence' bonds, as the auditing and investigation process is extremely strict. Even with such safeguards in place, the coverage is still quite expensive. Only the very safest QIs provide a very large "per occurrence" policy for each 1031 Exchange. A down market gives a potential buyer plenty of time to shop for the 'perfect' investment -- a luxury rarely available in a bull market. For many clients, the option to swap is one that they may not have considered. Real estate professionals should help clients understand that holding may not necessarily be their best choice in a down market. Sometimes swapping their property for a better one is the best way to help clients minimize risk and maximize return. Robert Pingeton is a northeastern region business development consultant and Stephen Wayner, Esq., C.E.S., is the first vice president of Bayview 1031