Wrinkle in tax code aids real estate deals

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Recently, Gary Gorman at Professional Exchange Accommodators, LLC in Englewood had a client involved in a 1031 Exchange — but one with a twist that is becoming more common.

Gorman's customer, a national real estate investor that recently set its sights on second-tier cities such as Oklahoma City and San Antonio, had a contract to sell an East Coast shopping center it owned for $25million with closing date of January or February 2000. The seller also had another commercial property — a package of five holdings in the North and South ranging from raw land to office and retail space — not only lined up but ready to grab for $60 million.

So as not to let the package get away, Gorman's client "bought" it before closing on the sale of its existing holding via what's called a reverse exchange.

Via the reverse scenario, the investor can buy another property before it sells the one it’s unloading.

The reverse exchange is a relatively new wrinkle in the Internal Revenue Code Section 1031, which allows the seller of a piece of real estate to buy another property right away to avoid paying capital gains tax. Via the reverse scenario, the investor can buy another property before it sells the one it's unloading. The term "reverse exchange" surfaced only last year in an IRS ruling on a utility easement.

"There are lots of reasons to do reverse exchanges," said Gorman, a certified public account and conductor of 1031 exchanges who started Professional Exchange Accommodators nearly five years ago. "It's a hot investment market, and properties are on the market for only a short time, so you may have to move fast to get one."

An investor with a 1031 Exchange in the works, for example, may expect to close on the property it's selling on Monday and ink the deal for the holding it's subsequently buying on Friday. But the buyer of the old property may change its mind, fail to get financing or require recently discovered environmental problems to be fully identified before closing, causing the Monday closing date to pass without a deal. On the other hand, the investor may be ready to buy the replacement property and, because there are other contenders for it, need to close of Friday, as arranged.

That's where the reverse exchange comes in. The investor gets the exchange property before it sells its own holding. But because the IRS won't allow the investor to take title to the new property before the old one has been disposed of, it must have an intermediary do the deal and hold or "park," the property until the investor has sold its older real estate. After that, the intermediary transfers title to the investor, its client.

The IRS requires that a qualified intermediary for 1031 Exchanges, or QI, to handle all exchanges, and they can't be the investor's real estate broker, lawyer, tax advisor or accountant. They must be independent, third-party exchange specialists.

"We hold people's hands," explained Gorman, whose company is a QI. "We help them do a transaction."

The 1031 Exchange is almost as old as the tax code itself, dating to the early 1900s and starting with housing before it expanded into commercial property. It has become popular in the Denver Area because of the recent local boom in real estate investment. Personal property, from aircraft to country club memberships, can also be exchanges; the key criterion in any "swap" is that it must be "like-kind" or an airplane purchase for and airplane sold, etc.

"The government wanted to encourage home ownership and not penalize home-owners from selling on houses to buy another," Gorman said, explaining the 1031's origins. "It felt the same way about store owners, so it let them do the same thing."

As the reverse exchange has gained momentum, it's also becoming more defined.

The IRS is setting up guidelines to better use it, including specifics for documentation. The federal government's taxing body expects to hand down a ruling on how to conduct one, largely because of a series of court battles, early next year. But because the IRS is understaffed, Gorman thinks it will more realistically come about mid-2000.

"Taxpayers have won and lost those court cases depending on documentation of their reverse exchanges," he added. "If you documented, you're OK."

This article appeared in The Denver Business Journal on November 26-December 12, 1999. Reprinted by permission. ©Copyright., The Denver Business Journal
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