1031 Exchange Investors Confront a Supply Pinch

july 2020 calendar

As commercial real estate investors scramble to meet a July 15 deadline for wrapping up 1031 exchanges, they’ve been running into trouble finding replacement properties. For one thing, there simply aren’t enough suitable like-kind assets to go around.

“The coronavirus pandemic has thrown the economy and real estate market into turmoil, leading to serious issues for exchange buyers, which means they are not the only investors trying to find a replacement property. They are competing against others who have that same July 15 deadline,” says Drew Reynolds, chief investment officer at Austin, Texas-based Realized Holdings Inc., which operates a 1031 exchange platform.

Because of the pandemic, the IRS in April pushed this year’s deadline to July 15 for identifying or buying a replacement property in order to complete a 1031 exchange deal. That’s the same day federal tax returns are now due, meaning investors who aren’t pursuing 1031 exchanges are also trying to close deals July 15 to take advantage of tax breaks.

Realized Holdings estimates current demand for 1031 properties is about three times higher than usual.

Further complicating matters: Some potential sellers have delayed putting their properties on the market, adopting a wait-and-see attitude regarding the pandemic and recession.

According to the IRS, Section 1031 of the Internal Revenue Code lets an investor put off paying federal taxes on capital gains from the sale of a real property if the proceeds are reinvested in a similar property through a “like-kind exchange,” or swap. Properties qualify as “like kind” if they’re of the same nature or character, even if they differ in grade or quality, the IRS says.

To qualify for 1031 tax benefits, a like-kind deal must be identified 45 days after an asset sale and wrapped up 180 days after the sale. For anyone whose 45- or 180-day deadline landed between April 1 and July 14 this year, the IRS shifted the deadline to July 15.

If investors aren’t able to execute a 1031 exchange before July 15, they could face a big tax bill for the gains they earned on the initial sale of their property. Through a 1031 exchange, an investor might generate hundreds of thousands of dollars in tax savings.

Bumping up against the new deadline, commercial real estate investors have been rushing to purchase 1031-worthy properties. Tax attorney Ken Weissenberg, co-leader of the national real estate practice at New York City-based accounting and advisory firm EisnerAmper LLP, says the market for available 1031 properties is thin. Realized Holdings estimates supply is “muted” by about 20 percent.

“Due to the limited supply and high demand, pricing may be getting too rich,” Weissenberg says.

Indeed, an investor might zero in on a viable 1031 property, only to find that they and the seller are miles apart on the asking price.

“The seller will probably want a pre-pandemic price, whereas buyers might be basing their bid on current economic uncertainties, such as double-digit unemployment and tenant uncertainty,” according to Realized Holdings.

Property types in high demand among 1031 buyers include drugstores, grocery stores and logistics centers. By and large, investors are hunting for properties in “COVID-resistant” sectors that have performed well during the pandemic, says Alex Madden, vice president of Torrance, California-based Kay Properties and Investments LLC, which operates a 1031 marketplace. Meanwhile, observers say, 1031 investors are shying away from asset classes like retail and office that have been beaten up during the pandemic.

Recent surveys of property investors by real estate crowdfunding platform EquityMultiple show that about half of them weren’t interested in tax-advantaged real estate investments like 1031 exchanges before or after the coronavirus outbreak. However, EquityMultiple polling after the pandemic struck indicates interest in 1031 exchanges has gone up.

Aside from striving to nail down the right 1031 properties, investors are also struggling to finance deals. Realized Holdings estimates that 80 percent of 1031 exchange transactions require a mortgage loan.

“The good news is that banks are sitting on strong capital reserves,” Reynolds says. “The bad news is that actually accessing that capital is becoming more challenging.”

Why? One reason is that banks and other lenders are dealing with a flood of forbearance requests and refinancing applications, according to Realized Holdings. Additionally, many lenders have been swamped by business applications for pandemic relief, including loans from the Paycheck Protection Program. Furthermore, some lenders have tightened their standards, such as demanding higher credit scores and lower loan-to-value ratios.

“Many prudent investors are identifying multiple properties in the event something prevents them from closing on their first choice,” Madden says. “Due diligence, financing and environmental reports have all become more difficult in the post-COVID world. As so many 1031 exchange investors are chasing after potentially scarce properties in the marketplace, it is possible more investors may be pivoting to their backup plans in order to prevent a potentially failed 1031 exchange.”

Industry experts say that some investors who can’t lock down 1031 deals before the July 15 deadline do enjoy a few backup options. Among them are Opportunity Zone funds and 1031 Delaware statutory trusts (DSTs).

Opportunity zone funds, established through the federal Tax Cuts and Jobs Act of 2017, offer several tax benefits for commercial real estate. For instance, an investor can defer capital gains from the sale or exchange of property when they invest the realized capital gains in an opportunity zone fund. Under this program, tax deferrals last until the end of 2026.

The federal government has designated about 8,700 Opportunity Zones nationwide where investors can pump money into economically disadvantaged communities. The Opportunity Zone program doesn’t mandate investment in a like-kind property in order to defer your gains.

Another alternative to a traditional 1031 exchange is a DST. This passive investment vehicle allows an investor to buy a share of a portfolio containing institutional-grade commercial real estate. But even DSTs are feeling the “supply pinch,” Reynolds says. DST-eligible inventory sits about 20 percent below where it normally does, according to Realized Holdings.

One big drawback of a DST: When you purchase an ownership stake, you lack control over the asset. But at the same time, you assume none of the headaches of a landlord when you invest in a DST.

There is another alternative to a 1031 exchange, but it’s far less attractive from a financial standpoint.

“Some investors have chosen to pay their taxes and not reinvest their proceeds using the 1031 exchange. For many investors, however, when they evaluate what that tax bill could be, they are looking to reinvest their proceeds,” Madden says.

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