Like-kind 1031 exchanges have green applications, among others, for some borrowers

Ricky B. Novak, president, and James W. Freeman, chief financial officer, Strategic 1031 Exchange Advisors

As published in Scotsman Guide's Commercial Edition, March 2010.

For decades, sophisticated property-investors have used U.S. Internal Revenue Code Section No. 1031 tax-deferred exchanges for real estate or personal property as an efficient tax-mitigation strategy. These exchanges have numerous benefits and potential applications to investment strategies, too.

As commercial property-owners continue to become more environmentally conscious, using a 1031 exchange when selling a property and purchasing another, "like-kind" property can help them accomplish their green objectives. Commercial mortgage brokers who understand basic 1031 principles, as well as how these strategies work and their potential effects, can best help their clients attain their goals.

Here's how.

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There are various 1031-exchange methods for property-owners. The most-common is a forward exchange. In it, a property-owner sells a relinquished property and acquires a replacement property within the necessary time frame. Other exchange structures include reverse, construction or build-to-suit, leasehold, and multi-asset exchanges.

In a successful forward exchange, an unrelated third party known as a qualified intermediary receives client exchange funds -- aka, cash boot -- when clients sell the relinquished property. The intermediary provides those same funds at the closing for the replacement property.

Upon acquisition of the replacement property, any debt of which the property-owner was relieved in the relinquished-property sale -- aka, mortgage boot -- also must be replaced. The property-owner must identify the replacement property within 45 calendar days of the closing of the relinquished-property sale and must acquire it -- or one of them, if multiple -- within 180 calendar days from the start of the transaction. To defer all capital-gains taxes on the transaction, the property-owner must purchase one or more replacement properties that equal or exceed the relinquished property's value.

Property-investors can realize many benefits from using a 1031-exchange strategy. These include the following:

• Immediate -- and potentially indefinite -- tax deferral: When selling an investment or business-related property, property-owners may defer the capital-gains tax as long as they acquire a like-kind replacement property. The deferred tax is not due until they decide to sell property without performing an exchange. Tax may be deferred indefinitely when an exchange strategy is coupled with proper estate-planning strategies.
• Improvement of investment returns: Investors may wish to sell an underperforming asset and acquire an asset with a more attractive cash flow, better appreciation potential or less risk. Additionally, a property-owner may wish to trade a nonincome-producing asset, such as raw land, for one that produces positive cash flow, such as a retail shopping center.
• Consolidation or diversification of real estate holdings: Property-investors may accumulate multiple properties and eventually decide to consolidate these holdings into a few larger assets. Conversely, they may own only one substantial property and want to diversify their holdings.
• Wealth-building potential: The greatest potential benefit that comes from using a 1031 exchange is the property-owner's ability to preserve equity in the relinquished property. The compounding effect of earning a continual return on all of the equity, instead of a portion of it, via the deferral of taxes due at the time of disposition can create a greater overall yield for the investor.

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