Are tax-related property shuffles inflating investment sales?

A growing number of investors are opting for so-called 1031 exchanges, in the wake of tax code changes that have increased the hit on selling real estate. But with more sellers exchanging higher and higher priced properties, some experts say the investment sales market is getting artificially inflated.

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 similar property within 180 days. Buyers must identify the second property within 45 days, and both must be within the same asset class, though the tax code doesn’t specify exactly what that means.

The protection, provided by Section 1031 of the Internal Revenue Code, has been used – often under special circumstances – for years. But New York City owners are increasingly relying on the provision when it comes time to sell, as higher tax rates swallow up a larger chunk of any potential profit, and lower interest rates mean that many traditional investments are less lucrative.

In fact, sellers float the possibility of a 1031 on almost every deal these days, according to brokers and CPAs who spoke with The Real Deal. In the last 12 months, sellers in more than 50 percent of the transactions completed in the northeast by commercial brokerage Marcus & Millichap were 1031 exchanges, the firm’s vice president of investments Joe Koicim told The Real Deal.

“Over the past five years, I might’ve seen one or two 1031s. So far this year, of the eight deals I’ve worked on, four of them have been 1031 exchanges,” said Matthew Bonney, a partner with Midtown-based CPA firm Citrin Cooperman.

At the start of the year, federal tax rates on properties edged up to 23.8 percent from 15 percent, partly the result of the so-called fiscal cliff deal and partly from the implementation of a provision of the Affordable Care Act, which added a 3.8 percent tax on net investments.

“Most of the sellers we work with have owned their buildings for 20-plus years, and in some cases they have been in the family for multiple generations,” Koicim said, noting that it does not make sense for that kind of buyer to pay capital gains taxes on the sales, given what can already be a thin profit margin.

There is “a lot more of a reason to roll over the gain, rather than take the cash,” Bonney said.

With interest rates at record lows, real estate offers some of the best potential for upside of any asset, and, in New York, many assets are a safe haven compared to the volatile stock market.

The exchanges “are back in vogue primarily because investors and owners are more comfortable that the credit crisis is behind us,” and they want to increase their allocation of wealth into hard assets, said Doug Harmon, senior managing director at Eastdil Secured.

But the uptick may also be causing the market to froth, sources said.

New kinds of 1031s

The major hurdle to a 1031 exchange, sources said, is finding a “like-kind” property within the six-month framework. With investors both sovereign and domestic currently salivating to park cash in New York City real estate, the risk of exchanging properties and not finding another asset to buy with the leftover money (which is left with an intermediary) is risky. Often, the upshot is that investors buy properties at prices and capitalization rates they otherwise wouldn’t.

“Some buyers are buying land,” as opposed to buildings, or taking lower-than-market cap rates on existing buildings in an effort to avoid the new, higher taxes, said David Schechtman of commercial brokerage Eastern Consolidated. “They will pay above market not to pay the usurious taxes.”

Would-be exchangers have mainly sworn off direct swaps because the risk of not finding the next property is too great, brokers said.

For example, the owner of a 14-unit rental building at 78 Irving Place in Gramercy, which sold yesterday, is now looking to do a 1031 exchange to increase the return on equity, according to the brokers who represented them in the sale. Similarly, an investor group led by Francesco Manica is looking to unload the $25.5 million generated by the sale of a luxury rental at 643-645 Ninth Avenue in Hell’s Kitchen, according to broker Emilio Barletta of Arlet Realty, who represented the seller.

“We have even seen an increase in the number of reverse exchange transactions, whereby the exchanger acquires the replacement property first, and then sells off the relinquished property within 180 days thereafter,” said Matthew Scheriff, an accountant with Legal 1031 Exchange Services, an accounting firm that specializes in the trades.

Self-fulfilling prophecy

But while 1031s have traditionally been used to preserve investments, the raging need for assets they create may be hastening the investment sales market’s upward climb — perhaps artificially so, sources said.

“We have buyers with cash in hand they need to protect,” Schechtman of Eastern told The Real Deal via email. “They will create sellers who may go ahead and do their own 1031s.”

Additionally, some sellers who have not immediately identified like-kind properties to purchase have stepped away from more straightforward swaps and placed the gains with an intermediary for use within 45 days – further heating up the investment sales market.

That approach “might push product along the line because people have cash they need to spend,” Bonney said. “I might not negotiate so hard because I have a deadline I need to meet.”

Koicim said he and colleagues at Marcus & Millichap recently arranged the $10 million sale of a 25-foot-wide property in the Meatpacking District where the buyer used 1031 funds.

“We had over 15 offers and ultimately a 1031 buyer appeared and executed a contract in a very short period of time and paid a significantly higher price,” he said. “The clock starts ticking the day you close.”

The uptick in 1031s may even lead to mortgages being placed on properties that were previously debt-free, which is particularly risky when it comes to owners with only a small number of assets and little income, Bonney said.

“They decide it is time to sell the building and cash out, but they don’t want to pay the tax so they do a like-kind exchange,” he said. “Then they place a mortgage on the property and take the cash.”

Meanwhile, some investors swear off the concept of exchanging properties tax-free entirely.

“I get why it exists in the tax code, but to me, it doesn’t make sense as a strategy,” said David Barry, president of Ironstate Development, a New Jersey-based developer of residential and hotel properties. “Conceptually I look [to invest in] the development business as I can build [projects] at seven caps and sell them at five caps if I want to.”

Still, the trend is likely here to stay, at least for a while, sources said. It feeds on a maxim brokers and investors agree on, Bonney said: “Generally, real estate people keep their money in real estate.”