In keeping with the worldwide green movement, commercial and residential property owners saddled with so-called brown buildings are being challenged to find ways for greater sustainability, social accountability and profitability. Unfortunately, many of today’s commercial buildings are anything but green. Outdated heating, ventilation and air conditioning systems, leaking pipes, old asbestos panels and mold can create a costly environmental nightmare.

Instead of undertaking expensive renovations and upgrades that may eventually pay off in higher rents and lower operating costs, many property investors are turning to 1031 tax-deferred exchanges to divest themselves of environmentally obsolete properties. By swapping a brown property for a modern, energy-efficient one, they are solving a considerable financial need and going green at the same time. (Brown properties remain attractive to some investors because of availability, price and location.)

Under IRS Code Section 1031, a taxpayer can defer payment of capital gains, depreciation recapture and other state taxes on the sale of investment or business property provided the proceeds are used to purchase replacement property within certain timeframes. To qualify for a Safe Harbor Protection tax deferral, proceeds must be held by a Qualified Intermediary between the sale of the relinquished property and the purchase of the replacement property.

For property investors considering exchanging their residential or commercial properties, going green offers a host of highly tangible benefits such as lower operating costs, greater leasing value, higher cap rates and increasing asset value. Green properties also tend to attract higher-class tenants.

Tax Strategy
Sophisticated property investors have used 1031 tax-deferred exchanges for many years as a highly effective strategy to preserve their wealth and grow assets by reinvesting part or all of the equity, plus tax savings, from the sale of the first building into the next property. Under a typical 1031 exchange, the owner relinquishes an income-producing property, then identifies and purchases a replacement property of equal or greater value in accordance with strict rules.

In a typical 1031 exchange, the owner can defer paying a 15 percent federal tax on any capital gains, all applicable state income taxes, and a possible 25 percent recapture on the accelerated depreciation and applicable state income taxes. A property owner who plans to go green with the new property may be eligible for a growing number of federal, state and local incentives as well.

The 1031 exchanges also provide flexibility as a real estate investment strategy. An owner can consolidate several holdings and purchase better-performing properties while deferring the tax consequences indefinitely. And 1031 exchanges can be used with virtually any type of business or investment property, including hotels, apartment buildings, shopping centers, warehouses, oil and gas, and even residential homes and land held for investment.

Because the green building movement is still in its infancy, many property investors seeking to capitalize on these benefits may be faced with construction and renovation issues. Fortunately, there are several variations on a traditional 1031 strategy that can allow an owner to develop or build a modern energy-efficient property and still enjoy potential tax advantages.

One 1031 exchange strategy is a reverse construction exchange. In this case, the taxpayer first closes on the purchase of the replacement property, and then sells the currently owned property within 180 days. A property investor could also purchase a new property while it is still under construction and enjoy the 1031 tax advantages, provided the current value of the new property is equal to or greater than the prior holding at the time of transfer.

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Stephen A. Wayner, Esq., CES., is first vice president of Bayview 1031, a Qualified Intermediary. Bayview 1031 is a subsidiary of Bayview Financial, a financial and real estate services company with more than $10 billion in assets and 2,100 employees.