Section 1031 Exchanges
Sellers have 180 days to buy a new property.
Enacted:

March 8, 1921

Reason:

Was a reaction to outraged farmers who were forced to pay 2 percent income tax on sale of farm property to G.I.s returning from World War I.

Requirements:

- Seller has 45 days after the transfer of a relinquished property to identify a replacement property of equal or greater value in writing.

- Seller has 180 days after the transfer of a relinquished property to close on the purchase of a replacement property.

- Property given and property received must be of a like-kind.

Source:

www.section1031.com

A Vernon manufacturer and importer/ exporter of baskets has paid $5.3 million to buy a strip mall in La Mirada. An unremarkable deal in many ways and yet illustrative of the investment real estate market today.

The remote, second-tier retail strip became an attractive buy for Fred Yazdinian's B.U. Group because Yazdinian was sitting on a pile of cash and the clock was ticking. Having already sold an industrial property, Yazdinian had 180 days to transfer the proceeds from his sale into another investment property or face a hefty capital gains tax.

With institutional investors sitting on the sidelines, the 1031 exchange (named after the applicable portion of the Internal Revenue Code) is becoming one of the few engines driving the investment game as owners of smaller properties cash out on years of appreciation.

"It's the bright spot in commercial real estate," said Jim Shaw, president and chief executive of CapHarbor Inc., a Beverly Hills-based consortium of investment companies that pair buyers and sellers in 1031 exchange deals.

The 1031 exchange buyer, looking for property in the $1 million to $15 million range, remains active while many other real estate sectors have come to a halt.

The motivation for a buyer of these smaller properties is different than the traditional, large institutional investor. By plowing the proceeds of a sale back into another property in a 1031 exchange, sellers can save as much as 20 percent in taxes.

Cash flow, not shelter

"The buyer needs to place that cash and they look for cleaner, stable projects," said Nicholas Coo, senior associate at Faris Lee Investments. In the deal for the La Mirada center, that meant buying a strip mall anchored by a 99 Cents Only store and a Goodwill Industries International Inc. thrift store.

Coo said 1031 exchanges account for 70 percent of Faris Lee's business these days, and that deals are happening all over: West Covina, Downey, La Mirada, Pasadena, Alhambra and Torrance.

"Most of them are driven by things other than short-term events," Shaw said. "They are utilizing the sale of relinquished property and investment in new property for estate and retirement planning."

Once a property is sold, the seller has up to 180 days from the initial closing to close on the new investment property. The deals don't have to involve a single property up to three properties can qualify, regardless of value, or a group of properties with a combined value that does not exceed 200 percent of the value of the sold-off property.

Using leverage

With interest rates at long-time lows, a 1031 investor can take his capital from the sale of a property and leverage himself into a bigger investment.

That's what the Shapiro Family Trust did when it spent $2.3 million to purchase a 40,360-square-foot warehouse and distribution facility on S. Main St. in Los Angeles.

Gary Blau, a broker at Goodglick Co. representing the trust, said the investor raised $1.4 million from sale of another property and used the proceeds to leverage the trade up.

"A 1031 buyer is somebody who's motivated because of time constraints, but if they look diligently they're not caught having to overpay for something because there's no time left," Maling said.

The 1031 exchange has initiated a number of more complicated variations, including deals where an investor buys an institutional-caliber property and sells part-interest in the property to more than one 1031 investor.

Though activity dipped in the days following Sept. 11, Shaw said the market had bounced back and remains strong. He said the 1031 exchange market had a higher number of transactions in October than in the same month a year earlier.

"Private capital clients have created value in their property and are upgrading their portfolios in asset classification," said Christopher Maling, senior investment associate with Marcus & Millichap. "It's always been going on, but more so now because there's been a rise in value to warrant someone saying, 'I'm not tied to this property and I've maxed it out as high as I can.'"

It might appear that because they are under the gun, a 1031 investor could be easy prey for an eager seller looking to squeeze extra dollars from a deal. But Shaw said that's simply a myth. People looking to buy under 1031 rules will often take the tax hit if they can't identify the right property. The failure rate of 1031 exchanges is around 15 percent, or $10 billion annually.

Nationwide, the real estate investment market amounts to $300 billion. Of that, Shaw suspected as much as $225 billion is accounted for by individual investors, the pool from which 1031 exchanges come.

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