Real estate auctions and 1031 exchanges: A powerful combination to maximize value

The primary goal of sophisticated investors and other players in the real estate arena is to maximize value.  Whether that encompasses buying at the lowest price or selling at the highest, determining a property's highest and best use, fully developing a property to the maximum of its potential, or seeking appropriate tax and legal counsel, the underlying principal objective is invariably the same. Traders of real estate employ various strategies to maximize value; two seemingly unrelated ones are, when implemented properly, extremely effective in attaining that goal together: the real estate auction and the §1031 exchange. A §1031 exchange allows a seller to defer the tax obligation on the gain associated with a sale by purchasing a qualifying replacement property. The requirements to correctly perform an exchange are rigid and sellers should consult appropriate tax and legal advice before attempting to execute one.  The major benefit is, of course, that sellers can keep their money in play as they make other trades to generate additional gains. A real estate auction is a structured sale where the seller sets all terms of sale, including those of the actual purchase and sale agreement, in advance. The subject property is marketed comprehensively to an extremely broad group of potential buyers using a number of marketing channels, including print media, online advertising, direct solicitation, the conventional brokerage community and a full public relations campaign. The goal is to reach every possible and, sometimes more importantly, unanticipated bidder for the property. The seller's property is subsequently sold and closed upon, all on dates designated by the seller, on an as-is and non-contingent basis.  That is, prospective buyers must perform all due diligence before auction day, when the successful high-bidder will be required to sign a contingency-free contract and deliver certified funds, leaving the seller with a non-refundable contract executed by an informed and qualified party. One of the auction's many benefits is its inherent deadline, which forces buyers to act immediately or risk losing the asset. It preempts buyers' typical strategies, which usually include low offers and an inclination to wait for sellers to reduce asking prices. Actually, in an auction, there is no asking price; bidding begins below market and stops at the point when no one is willing to pay more.  Effectively, the auction establishes value without setting a ceiling on price, which causes properties to sometimes trade for premiums. Furthermore, an auction will eliminate the prolonged carrying costs associated with conventional sales processes. It will focus the market's attention on the subject property, freezing the sale of competitive product within the marketplace—a tremendous value-added in this market. In conjunction with a §1031, the auction maximizes value in a defined timeline and allows the seller to defer taxes on the gain associated with the auction sale. In fact, in order to properly execute a §1031, the seller must comply with extremely stringent timing requirements (generally, a replacement property must be identified within 45 days of the closing of the relinquished property and must be closed upon within 180 days of same). Perhaps the most significant advantage for sellers seeking to reap the benefits of both strategies is that, in an auction, the timeline for due diligence, inspection, sale and closing are determined almost unilaterally by sellers. Only via auction can one sell property in a manner entirely consistent with the seller's trading (i.e., §1031) objectives. While the auction and §1031 processes work well together generally, the auction even more naturally complements the less typical, reverse §1031 (where the replacement property is actually purchased before the relinquished property is sold). When conducting a reverse exchange, the exchanger only has 180 days to close on the sale of his property—making the auction the ideal accelerated program through which he can maximize value in the specified timeline. In summary, the structured, seller-friendly nature of the auction is an ideal mechanism that allows principals to trade property in a manner that complies with the strict requirements of a §1031 exchange, providing sophisticated investors with two very effective strategies for maximizing value as they manage their real estate portfolios. Misha Haghani, Esq., is an attorney and the director of Sheldon Good & Company Auctions Northeast, LLC, New York, N.Y.