1031 Exchanges Come Roaring Back to the Market

 

Welcome back old friend! Yes, we have seen a re-emergence of the blessed 1031 tax-deferred exchange in recent weeks, and what a welcome sight it is.

The opportunity to protect hard earned equity in the sale of an investment has been available to investors since 1921. However, this part of the tax code was so complex that only a small segment of the investment community took advantage of this mechanism.

In 1990, the Omnibus Budget Act provided more widespread access to a broader set of investors as this option was clarified and simplified. Section 1031 exchanges are often mischaracterized as “tax free” when they are actually “tax deferred”.

The theory behind this mechanism is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay taxes. Only the form of investment has changed, therefore, it would be unfair to collect a tax on a “paper” gain.

When an investor utilizes this mechanism, the deferred gain is payable when the replacement property is sold and is not part of yet another exchange. At that point, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

1031 exchanges in the investment property market have been growing in popularity since the mid-90s and fueled a majority of transactions in the mid to late 2000s. With falling property values and transaction volumes beginning in late 2007, we saw a significant reduction in 1031 transactions.

In previous StreetWise columns, I have gone into detail about the supply / demand imbalance and the fact that the volume of sales was so low due, mainly, to lack of supply as opposed to waning demand. The supply of available properties for sale is generally fed by discretionary sellers. When value falls, as it has done since 2007, discretionary sellers withdraw from the market and the supply is then fed by distressed sellers. Distressed sellers have not fed the supply in numbers which were expected because everything that has occurred from a regulatory perspective has allowed these sellers to avoid dealing with their distressed assets.

Recently, we have seen the flow of distressed assets begin to loosen as banks and special servicers are beginning to clean up their balance sheets and portfolios. Simultaneously, we have seen discretionary sellers returning to the market. The tangible evidence that this is actually happening can be seen in the 1031 activity we have seen recently. Distressed sellers are rarely left with any equity to reinvest in the form of a 1031 exchange. Discretionary sellers, on the other hand, often have significant equity to redeploy via this tax-deferred vehicle. We are, once again, seeing sellers ask for flexibility in closing periods to provide them with better chances of being able to effectuate an exchange.

During the past 4 weeks alone, we have signed 12 contracts with purchasers who are investing 1031 funds. Moreover, we are receiving multiple calls each day from investors who are looking for properties to complete exchange transactions. This is certainly reminiscent of 2006 and 2007 when so many transactions were motivated by tax-deferment. The demand side has been very strong for quite a while as institutional capital has returned to the market, joining the high-net-worth individuals and families which have dominated the horizon for the past couple of years. Foreign high-net-worth investors are present in rapidly growing numbers and the re-emergence of 1031 capital adds more pressure to already overwhelming demand for investment properties.

Don’t mistake my perspective as I am not suggesting that market conditions are back to the go-go, bubble inflating, years of 2005 to 2007. I am, merely, passing along a trend that we are seeing which has, for the most part, been absent for quite a while. It is yet another sign that the recovery is upon us.

From an intermediary’s point of view, or anyone’s, who is reliant upon transaction volume for their livelihood, it is positive to see this type of activity returning to the market. To the extent that distressed sellers continue to dispose of assets and discretionary sellers return to the market, transaction volume has no choice but to increase. As sellers with real equity sell, each transaction is likely to stimulate another transaction as a 1031 is contemplated.

This trend certainly bodes well for our projection that transaction volume will increase by about 40% this year over last year. Welcome back old friend, indeed!

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having a market value in excess of $6.2 billion.

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19 Responses to “1031 Exchanges Come Roaring Back to the Market”


  1. 1 Tony B. May 9, 2010 at 9:15 am

    Bob, this is a very positive development for the sales market. Thanks for keeping us on the cutting edge of emerging market trends.

  2. 2 rknakal May 9, 2010 at 9:37 am

    Hi Tony, thanks for your post and the kind words.

  3. 3 William L. Exeter May 10, 2010 at 12:29 am

    Great to hear that you are seeing the same thing. We have seen our business increase over the last two months, too.

  4. 4 Mike Franklin May 10, 2010 at 9:13 am

    Bob, Well researched, well said. We are fielding an increased number of calls as well from investors with equity looking to complete that wealth-building exchange.
    Thanks

  5. 5 chiqui May 10, 2010 at 3:12 pm

    this is commercial vs residential that you’re discussing, yes?

  6. 6 Brigitte Echave May 11, 2010 at 5:20 pm

    Thanks for sharing this information. We have noticed in Arizona an uptick in activity as well. Our call volume has increased steadily since January and we have noticed more investors have decided to move their monies to new investments through the 1031 Exchange vehicle. Glad to hear that this is happening in your part of the country as well. Brigitte

  7. 7 rknakal May 11, 2010 at 9:05 pm

    Hi William, thanks for the post. What market are you active in?

  8. 8 rknakal May 11, 2010 at 9:06 pm

    Hi Mike, thanks for your post. You are correct, the numbers of calls do not lie.

  9. 9 rknakal May 11, 2010 at 9:07 pm

    Hi Chiqui, thanks for your post. All of my comments relate to the commercaial building sales market.

  10. 10 rknakal May 11, 2010 at 9:10 pm

    Hi Brigitte, Thanks for the post. If Arizona is picking up, it is a VERY good sign for the entire country. Thanks for sharing your insights.

  11. 11 Sean O'Shea May 12, 2010 at 10:44 am

    Bob:

    We, too, can verify recent encouraging disposition decisions being made and executed = IRC 1031 Replacement Solutions needed.

    As we have discussed in the recent past, the bid/ask spreads and the debt/leverage assumptions need to be re-calibrated by both Buyers and Sellers, alike. With interest rates hikes ‘looming’ and the Federal Cap Gains moving to 20% in 2011, this is the moment for seasoned and savvy investors to craft Disposition Strategies for 2010……..not waiting until Q3 of 2010 in an end-of-the-year ‘Mad Dash’!! NOW!!!
    Best to you, Sean

  12. 12 JMeli May 13, 2010 at 10:50 pm

    It is slightly different from the early 1990’s. Back then, prices tanked and buyers picked up properties for under 4XRR. Today, with global FIAT currencies in a race to the bottom, many seek for preservation of capital rather than turning a profit. That is why you see the 2000’s continuation of “dumb money continuing to chase smart money”. Eventually as deflation is fought with quantitative easing, counter-intuitively, money velocity will settle down as it did in the early 90’s and PE’s for apartment buildings will come back down to turning profits.

    The FED wants the velocity of money to increase and it eventually will in 3-5 years. Once that happens, preservation of wealth will take a back seat as necessities (commodities) will chew deeper in American budgets.

  13. 13 rknakal May 16, 2010 at 8:43 am

    Hi Sean, thanks for your post. You make a great point about getting started now. I advise all of my clients to plan ahead as time moves more quickly than any of us would like. Particularly lenders who are so quarter-driven. If they wait until there are only 6 weeks before a quarter ends and expect a transaction to close by the end of the quarter, they may have to absorb a discount to make that happen.

  14. 14 rknakal May 16, 2010 at 8:46 am

    Hi JMeli, thanks for your post. It will be intersting to see what the future will bring. Time will tell…

  15. 15 Rick M. Bean May 20, 2010 at 2:08 pm

    Great article! Our experiences mirror yours…increased activity of the real estate investment market in general, and in the 1031 Exchange sector specifically. Off market deals are exploding.

  16. 16 ANITA WYRGATSCH May 21, 2010 at 10:07 am

    Mr. Knakal, Thanks for the timely post on this most important subject. We are seeing the same pick up in 1031 transactions.


  1. 1 1031 Exchanges Come Roaring Back to the Market « StreetWise | The 1031 Blog Trackback on May 9, 2010 at 8:56 am
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