Tax measures give investors 1031 reasons to buy real estate

The number of individual real estate investors turning to a tax-saving measure known as a 1031 exchange is rising dramatically as they seek to escape the clutches of the Internal Revenue Service.

A 1031 exchange allows an investor to defer capital gains taxes if the proceeds from the sale of one property which has been owned for at least a year are used to buy another property within 180 days.

The tax provision is being used by the many investors who’ve opted for real estate rather than the stock market. Investor appetites for equities have cooled, as money has moved to bricks and mortar.

Stephen Wayner, vice president of Bayview Financial Exchange Services, which facilitates 1031 exchanges, says the measure’s main advantage is allowing the use of “leverage to buy with pretax dollars rather than post-tax dollars.” If a buyer can use a 1031 exchange, taxes can be deferred.

Wayner declined to reveal the number of exchanges the firm has done, but said it’s up 50 percent in the last three months.

“The volume is unbelievable,” he said.

In New York, many wealthy investors use 1031 exchanges to buy one or more condominiums for investment purposes, said Eric Lustgarten, senior vice president of Brown Harris Stevens Project Management and a director of residential sales. “There’s been a tremendous increase in the past few years.”

That’s because major brokerages are going after investor dollars, teaming up with financial services firms to find buyers. Brown Harris Stevens and Merrill Lynch & Co. teamed up last fall to present a symposium on integrating portfolio management and real estate.

“Merrill Lynch and a lot of investment firms have little way to assist clients in (finding) these types of investments,” said Lustgarten, who represented Brown Harris along with fellow broker Nancy Hertzfeld.

Clients have been receptive, he said. In one instance, a real estate investor sold a home that was being used as an investment property in California and used the proceeds from that sale to buy a New York City apartment being leased by a major corporation. The investor used a 1031 exchange to defer paying taxes on the property sold in California and made a 6 percent to 8 percent return on investment from the rent from the New York apartment.

“It works well for pre-construction condominiums,” Lustgarten added.

Wayner recommends that anyone doing a 1031 exchange get a tax opinion letter from a certified public accountant before completing the transaction.

A 1031 future

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The investment adviser-real estate broker alliances may be helpful because investment firms are rarely licensed real estate brokers, and the securities industry is so heavily regulated that it might not be worth it for a firm to try to delve into the real estate brokerage business.

Some financial products bring real estate and securities together. Merrill Lynch, for example, offers loan products that investors can use to buy property. Its Loan Management Account allows customers to borrow against assets in securities accounts held with the firm, rather than raiding cash reserves or selling assets. The loans can be used for a variety of purposes, including buying investment property.

In the securities industry investors are typically advised to allocate 5 percent to 20 percent of their portfolios to real estate investments, said Bruce Barth, senior vice president of investments at the Barth/Wolf Group at Merrill Lynch in Newark.

Barth, a certified financial planner and a wealth management adviser, said one client who wanted to diversify his assets developed and built a small neighborhood shopping mall.

“It’s now in phase two of expansion and is a good source of cash flow,” Barth said.
CB Richard Ellis formed a private client group for real estate investors about four years ago.

“It was a reaction to our read of the market that showed that individual investors had different needs than our institutional clients,” said Bob Burke, senior managing director of CB Richard Ellis Investment Properties/Private Client Group. Although the value of private equity deals varies, real estate investment purchases among high-net-worth individuals tend to range from $1 million to $20 million.

CB Richards Ellis uses its web site to connect individuals with real estate deals. A potential buyer can input what kind of property they are looking for, the desired price range, geographical parameters and other information into its web site. The company will then e-mail information on available properties that meet the client’s criteria. Depending on financing arrangements, commercial real estate investments can yield 8 percent to 10 percent returns, according to Burke. That could augment income from other retirement investments. “Thirty years ago people had pensions, now they are looking for preservation of capital and cash flow that real estate can provide,” Burke said.

Fifty percent of CB Richard Ellis’ customers buy a property in a state other than where they live, sometimes putting the property under contract even before taking a trip to see it, Burke said. One client recently sold an apartment building being converted to condos in San Diego and then purchased a shopping center in Texas with a greater expected rate of return, Burke said.

Not everyone is well-suited for investing in property. If a person doesn’t have time or simply doesn’t want to manage a property and they don’t want to hire a company to do it for them, investing in property may not be a good choice.

Security through real estate securities

However, some firms such as Bailard, an investment firm near San Francisco, have securitized the sector, setting up private real estate investment trusts that are open to customers who can invest around $500,000. The firm buys and maintains properties and investors can redeem shares quarterly, said Ronald Kaiser, director of real estate research at the firm and a director of the company.

The enthusiasm for real estate investments today invites comparisons to the technology bubble of the late 1990s. Barth says he’s heard of people using all of their money from Individual Retirement Accounts (IRAs) to buy real estate, “and that’s dangerous.” Still, it’s hard to pinpoint how fragile a potential bubble might be, he said. Strong foreign currencies such as the euro may make property in markets such as New York very attractive to foreign buyers and keep prices rising, Barth said.

Still, as prices rise, fewer and fewer people can afford to buy, which is why portfolio diversification remains key, according to Barth. “All trends come to an end, we just don’t know when,” he said.

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