Savvy real estate investors like Schooley are employing property swaps (also known as 1031 property exchanges, after Section 1031 of the tax code) as an alternative to selling properties for cash and paying the 15 percent capital gains tax. One of beauties of swaps is that they permit investors to trade properties repeatedly for others of equal or greater value, as long as the transactions involve no cash. A wisely executed series of transactions can allow the owner to speculate in a wide array of properties while postponing the payment of capital gains taxes throughout his or her lifetime.

Since the IRS tax law is a national code, real estate can be traded throughout the 50 states. For example, a shopping mall in Texas can be exchanged for properties anywhere in the United States—a seaside condo complex in California, an industrial park in Connecticut, or even a resort with a yacht marina in Florida. Moreover, one property can be swapped for several: The IRS’s three-property rule states that investors can exchange one property for up to three others, regardless of their market value. The 200-percent rule allows investors to swap one property for unlimited multiple properties, as long as the aggregate fair-market value does not exceed 200 percent of the fair market value of the property being swapped. To reap tax-deferral benefits, both the property that is swapped and the one received in exchange must be used strictly for investment or business purposes. In addition, the swapped properties must resemble one another. Investors must also conform to an IRS-mandated timetable: After trading a property, owners must identify the replacement within 45 days, then close on that replacement property within 180 days.

Avoiding The Boot
One snare that can cause these deals to run afoul of the IRS is a boot. This consists of either a cash gain or a reduction in debt on a property. Says Schooley: “If you walk away from a swap—whether at the first closing or after the completion of the swap—and you have cash in your pocket, that’s a taxable boot.” A liability boot, in which debt is reduced when a debt-laden property is swapped for one with a lower price, is another wrinkle to avoid. If, for example, an investor sells a $1 million property that carries $500,000 of debt, then buys an $800,000 property with $300,000 in debt, though the sale does not generate cash, it does pay down the original debt. “That is a liability boot, and it is taxable,” notes Schooley, who is CEO of 1031 Accommodators LLC, a firm that acts as a middleman for these deals—usually for a fee of 1 percent to 2 percent of the value of the relinquished property.

“The investor who is exchanging his property cannot get his hands on any of the money during the whole swap process,” says Frank Kovats, director of Kovats Real Estate and Insurance School in Maywood, N.J. “If he does, he’s disqualified from deferring any taxes.” When investors decide that they are going to sell their investment properties, they enter into a contract to sell them to buyers, who turn around and assign the contract to a third party called the qualified intermediary. All money placed in swapped properties is channeled through the intermediary. When the investor locates a replacement property, he enters into a contract to purchase it, and the qualified intermediary enters the picture.

Choosing a competent qualified intermediary is crucial. They are not licensed, as are brokers. Obtain recommendations from the intermediary’s former clients, Kovats advises. Then ask a litany of questions. How long has the intermediary handled trust accounts? In how many transactions has he or she been involved? What were the dollar amounts of the transactions? “In some cases the qualified intermediary might not charge a very large fee, but he might say that he has the right to retain the interest that’s earned on the money he holds during the course of the transaction,” Kovats warns. “If he wasn’t willing to discuss these things with me, that would be a red flag; I’d move on.” 

Comparison shop among qualified intermediaries in order to examine the range of fees, advises Tim Egan, executive director of the Federation of Exchange Accommodators in Sacramento, Calif. He points out that fees vary according to geographic area.

Portfolio TICs
Some investors are exchanging properties for fractional interests in Tenant in Common (TIC) properties, which include large properties such as shopping centers, office or apartment buildings, or industrial sites run by managers. With a fractional ownership in a TIC, the investor acquires his or her own deed and title policy to a property that is shared with other investors. A TIC differs from a real-estate investment trust (REIT) in that investors are actual owners of the property, whereas as in the latter case, investors only receive shares.

Investing in TICs is more expensive than buying a property on our own, but the returns may justify the effort, according to Gary Beyson, CEO of OMNI Brokerage, a commercial real estate broker in Salt Lake City. The reason: TIC investors are paying for the services of a so-called “sponsor.” Sponsors find the property, buy it or put it under contract, and arrange for the financing (on occasion, negotiating better financing than individual investors could manage themselves). They may also bring together investors who pool their money to buy a large TIC property.

The TIC fee, or load, ranges from 15 percent to 20 percent of the amount that the TIC investor is swapping. So if we are investing $1 million, about 15 percent to 20 percent of that amount will go toward the fee. Part of the fee pays the broker; another portion compensates the sponsor who has packaged the TIC prop-erty. However, an investor who buys a property swap outright pays less in commission. Since the inves-tor swaps his property for a replacement found by a real estate agent, the commission is based on the purchase price of the property. That means if we exchange a $1 million property for a $2 million one, we may pay the real estate agent about 6 percent of the $2 million, compared to the 15 percent to 20 percent paid by the TIC investor.

Diversifying among various types of commercial real estate in various states spreads one’s risk across a broader allocation of assets. “If I had all my properties in one area,” notes Andy Mendell, a real estate broker, “and something happened—for example rents on San Francisco residential properties dove 40 percent—that means my income’s gone down 40 percent.”

An added plus to harnessing TICs is that they can be set up as separate, independent limited liability corporations (LLCs). This strategy protects investors from worst-case scenarios, such as discovering that a property has a toxic dumping problem, for example, that it is going to cost twice as much to clean up as the property is worth. “The [liability] should stay in that property,” says Mendell. When an LLC is correctly structured, the investor’s other assets are insulated and protected from lawsuits resulting from a problem property.

“It’s as if you had five different businesses,” Mendell says, referring to TICs. “If one business goes bankrupt, and the corporation is correctly structured, [the bankruptcy] should not affect your other businesses or your personal assets.”

In Austin, Texas, David Reue invested in three TIC exchanges. “I sold a lot in Austin that we were going to build a house on,” he says. “We had owned the lot for a few years, and it went up quite a bit in value. Finally, we elected not to build on it and to sell it instead.” Reue took the proceeds from that sale and placed it into three TIC exchanges: a shopping center called Washington Square in Texas; a student housing condo development in Provo, Utah; and a medical office building in Davis, Utah.

With these TIC investments, Reue solved two problems: He avoided investing in an uncertain stock market and, more importantly, he deferred about $80,000 in taxes at the time of the sale. Also, he did not have to search for the swapped properties himself, since the broker-dealer he employed performed that step for him. “I didn’t have any idea even where to start looking,” he admits. He chose to acquire an interest in the medical office building because it is a very stable property, he says. “It was essentially 100-percent leased, so there was already a definite amount of income that the property was generating.” The student housing facility, Reue observed, probably had sizable upside potential that would be realized when he eventually sold that property. “At that time, we can exchange the proceeds from the student housing property into another property swap,” he says. Of course, taxes are continually deferred as well.

Reue did, at closing, pay a fee of 14 percent of the total value of the property that he swapped for fractional ownership in each of the three replacement properties. “At this point, we’ve had no negative experiences,” he says. “However, if the real estate market happens to take a slide, you might lose the value of whatever you have exchanged into.” In the meantime, he receives an 8 percent to 10 percent return on each investment, which comes in on a monthly or quarterly basis. “I’m happy with that,” he says, “and I don’t have to do any management at all.”