Here are some guidelines to help you assess the value of 1031 exchanges.
New private placement deals involving 1031 real
estate exchanges are becoming popular. But before you start swapping
your clients' property to defer capital gains taxes, check out the
Andrew Rosenberg, a Coral Springs, Fla., attorney and CFP, estimates he's putting into "tenant-in-common 1031 exchanges" three of ten investment property clients seeking to defer capital gains from the sale of their properties. These turnkey investments are hailed as a way to remove many of the chief obstacles in deferring capital gains taxes on investment property. As much as $4 billion has gone into these real estate deals, the NASD believes.
With a Tenant-in-Common 1031 exchange, the investor receives a deed for an undivided interest in real estate and shares in the risks and benefits of ownership. Sponsors structure the instrument, manage the property and negotiate the sale price and loan. These investments often are unregistered, and fall under the Regulation D exemption of the Securities Act of 1933. They frequently are limited to accredited investors, and are subject to advertising prohibitions.
Rosenberg, senior partner with Andrew Stuart Asset Management Group Inc., works with as many as eight sponsors of these deals. This way, he can diversify clients to lower the risk. If a client just sold a property for $1.5 million, he'll put proceeds from the sale into three different types of real estate, such as apartments, commercial office buildings and industrial property.
These nouveau investments sprang from a landmark March 2002 IRS ruling. IRS Revenue Procedure 2002-22 outlined conditions permitting the pooling of investment property owner funds for the purpose of conducting "1031 exchanges." Under Section 1031 of the Internal Revenue Code, investment property owners can defer payment of capital gains taxes by "exchanging" the property for another investment property of equal or greater value. Conditions: The investor generally must identify the replacement property within 45 days of the sale of the old property and acquire the new property within 180 days. Partnerships are ineligible.
Sponsors of these "tenant-in-common 1031 exchange" programs claim they'll handle the time constraints. They take care of the 1031 exchange rule's other red tape, including arranging for a third party, or "qualified intermediary," to hold funds for the deal.
Besides helping to defer taxes, including capital gains and depreciation recapture, these investments let investment property owners trade up to a larger property, says Todd Williams, vice president and attorney for one sponsor of these deals, Argus Realty Investors LP in San Juan Capistrano, Calif.
The IRS sets 15 conditions for a tenant-in-common 1031 exchange, including a limit of 35 investors. Investors may invest as little as $100,000, depending on the program. At this writing, the annual rate of return on these replacement properties was running about 6%, Williams says. Historically, they've returned as much as 8.5%.
Tenant-in-common 1031 exchange deals often have short life spans of five to seven years. But some say the terms are increasing as sponsors try to lock in loan rates over a longer term.
There are several unresolved issues with tenant-in-common 1031 exchanges. For one thing, the deals may be structured either as securities or real estate deals. The conflict has pitted the real estate industry against the securities industry. Experts say the majority-some 80% of the deals-are structured as securities. In fact, NASD Notice to Members 05-18 appears to favor considering them a security. Anyone who sells these 1031 investments, according to the NASD, should have a Series 7 or Series 22 securities license.
By contrast, the National Association of Realtors says they are real estate investments first. At least 42 states require persons who sell them to have a real estate license.
Bottom line: Financial advisors selling these programs may need to comply with a state's real estate regulations, and real estate personnel selling them may need securities licenses.
"The great majority of products we've seen fall, in our view and also the view of the SEC [Securities and Exchange Commission], as being securities," says Gary L. Goldsholle, NASD associate vice president and associate general counsel for regulatory policy and oversight. NASD's Notice to Members 05-18 clarifies that "the fact that they are investment contracts does not inherently disqualify them as property that may be exchanged under Section 1031."
If a deal goes bad, expect an investor's first charge to be that he was sold a security without a license, warns Tim Snodgrass, president of the 267-member nonprofit Tenant-in-Common Associa-tion, Sacramento, Calif., and the for-profit Argus Realty Investors LP.
Al Mansell, president of the National Association of Realtors, argues that 1031 exchanges were pioneered by the real estate industry. And investors in real estate-only deals typically have more control over management. While president of the Utah State Senate last year, he spearheaded recently adopted legislation that permits tenant-in-common 1031 deals to be either real estate or securities transactions in that state. Investment property owners, looking to invest in a tenant-in-common 1031 exchange, he maintains, should have a choice.
However, there are problems with splitting commissions or paying referral fees to real estate brokers. NASD warns that a broker-dealer who pays a fee to a real estate agent or splits brokerage commissions with the agent in connection with one of these deals may be in violation of NASD Rule 2420. That rule prohibits payment of commissions and fees to unregistered broker-dealers.
The Tenant-in-Common Association says it is working with regulators and the National Association of Realtors to iron out differences. Its concern: that all professionals in these deals get paid.
Tenant-in-common 1031 exchange deals may have hidden costs or inflated projections. Example: Real estate deals may look cheaper for a client. Typically, the investor would pay a 3% commission to a real estate broker for a 1031 exchange deal. By contrast, broker-dealer commissions run 6% to 8%.
But Snodgrass says a real estate broker's 3% commission may be factored on the investment's total debt and equity. A broker-dealer's 8% commission may only apply to equity. So on a property that has $300,000 in equity and $700,000 in debt, the real estate broker could be getting a $30,000 commission while the registered rep would earn just $24,000. Also, experts say that sponsors may take a cut of the deal before selling it to an investor. Plus, figures in offering documents often are based upon projections, which easily could be inflated.
Other issues to consider with these real estate deals include:
Lack of experience. Tenant-in-Common 1031 deals are, for the most part, only two to three years old. Many have not even matured, so how profitable they are remains a question.
Lack of liquidity. There is no secondary market for tenant-in-common securities. Nor is there a multiple listing service for them. If an investor in a five-year program needs to get out in year three, he or she could be stuck. Often, however, co-owners may have an option to buy out others.
Most lenders issue a loan to those who hold title to the property, and likely won't allow anyone else to assume it. If one borrower defaults, the property could be encumbered. Williams says reputable companies often negotiate nonrecourse financing, so that the lender can't repossess the property and sue investors.
Deals generally are based on leasing income. The loss of tenants or lease problems could affect the investment. Williams says his company puts a few million dollars in reserves in case of problems. If there are no problems, the investor gets money back when the property is sold.
Tax consequences of deals. Scott M. Estill, tax attorney and author of Tax this! (Self-Counsel Press), has seen many a 1031 exchange deal unravel due to failure of the investor to identify a property within 45 days and close within 180 days. As a result, the investor must pay capital gains taxes and depreciation recapture he or she got into the deal to avoid.
The NASD advises that members obtain a "clean" legal opinion that a tenant-in-common interest "should" or "will" qualify for exchange under 1031. Estill adds that advisors considering such a deal should heavily investigate that third party "qualified intermediary" to make sure the person can comply with all the IRS requirements.
Investors likely don't realize all the risks. Seth Pearson, CFP with Pearson Financial Services in Dennis, Mass., specializes in real estate planning, but avoids tenants-in-common deals. He redirects clients, instead, to private annuities, charitable gift annuities or charitable remainder trusts.
His complaint: The whopping, 80-page-plus Personal Placement Memorandum detailing the deal frequently comes at the very last minute. Yet, every one he has ever seen has been riddled with conflicts of interest, lack of liquidity and reliance on third parties. "When you read the (offering document) you won't like what you read," he declares.
Local municipal regulatory approvals may be needed for real estate. Tom Pool, spokesman for California's Department of Real Estate, warns that in his state, transactions may need various approvals-such as permits for subdivisions-from local municipalities.
Advisors must consider fiduciary duty issues, suitability issues, and must have competence necessary to evaluate several different programs. The NASD also warns that members should consider whether tax-deferral outweighs fees charged in this program, and whether the deal represents a complete tax-free exchange.
Gail Liberman is a contributing editor to Financial Advisor. She also has Florida real estate and mortgage broker licenses. Her latest book is Rags to Retirement, published by Alpha Books.