26A — September 13 - 26, 2013 — Mid Atlantic Real Estate Journal
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M id A tlantic R eal E state J ournal By Stan Freeman, Exchange Strategies Corporation The Optimal Exchange Strategy – Transaction Timing Control
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tive ease. If not, fire your Broker and get a ont. from page 3A
available to the landowner and specifically, what form of condition would constitute a violation. These matters were remanded to Florida state court for a decision. Despite the lingering ques- tions, this case clearly extends the reach of Federal constitu- tional law into the local land use process. Denials of permits where applicants fail to agree to mitigation “suggested” by an agency, and any monetary conditions imposed on permits, are now subject to higher scru- tiny. This is clearly good news for landowners. However, this decision may prompt some It is very important to un- derstand that there is also a 45-day identification require- ment in a reverse exchange but it applies to properties that you already own, that is, potential Old Property. In essence, the 45-day ID deadline in a reverse is satisfied by deciding which of the assets you will try to sell. And, once you have taken the time to find and acquire a New Property that satisfies your investment objectives, you now become a seller in a seller’s market! This can be profoundly different because you will be the beneficiary of the seller’s market rather than one of its “victims” - trying to buy assets for which the competition is intense. You should determine for yourself how much risk to your overall strategy is ber of reasonable potential New Properties can be a huge challenge. And, it does happen - with scary frequency - that an investor identifies three prop- erties and is unable to acquire any of them, perhaps because they were lost to a competing bidder or to a foot-dragging lender or...whatever. The risk of not being able to complete an exchange once the Old Proper- ty has been sold is much higher in today’s market than at any time in recent memory. Enter the reverse exchange. This form of 1031 exchange is accomplished by acquiring the New Property first and sell- ing the Old Property within 180 days of the purchase. The role of the QI is to hold title to one of the properties in the exchange, rather than to hold the cash proceeds of the Old Property sale, as in a forward exchange.
municipalities to enact more restrictive ordinances in place of the give-and-take negotia- tions that often accompany ap- plications. Is that really what we want? I wouldn’t be surprised if we see such a great deal of caution before discussions take place about potential exactions, even those that are obviously benefi- cial to the project and commu- nity. The potential result could simply be less communication and more litigation. Neil is a partner of Kaplin Stewart in the Land Use, Zoning & Development group. n If you have no other way to make the acquisition first, then your only option is a forward exchange and the rest of this discussion may be irrelevant. A much more sophisticated way to look at both of these issues is to look at the cost of exchanging. To get an idea of the real cost of exchanging, consider the following factors. First, in a forward exchange, once the Old Property is sold, you receive no financial ben- efits from it at all; if the Old Property was income-produc- ing, then the rent you used to collect goes to zero and there is no further benefit from depre- ciation or appreciation of the asset in the current market. Further, the cash proceeds of the Old Property sale will be held by a QI, with the finan- cial benefits of that cash being taken by the QI as its revenue. You get nothing or almost nothing. By contrast, and this is one aspect of reverse exchanges that is often not well under- mitigated by taking the time to acquire what you need or want and then be able to identify and sell candidate Old Proper- ties from among those in your portfolio. Many, many CRE investors have come to realize that this is better way. However, there are two ob- jections that come up fre- quently. First, acquiring the New Property first means that the funds from the sale of the Old Property are not yet avail- able and other money must be found to make the acquisition. Second, the fees for doing a reverse are said to be high and the complexity difficult to deal with.
stood, for reverses involving income-producing properties, as the exchanger, you receive the rental income (and obli- gations) from both Old and New Properties during the exchange period. For example, if your Old Property gener- ates $5,000/month in rent and you are exchanging into a New Property that generates $10,000/month, then during the exchange period (up to 180 days), you are receiving rent totaling $15,000/month! The fact is that a dual rent stream almost always offsets both the fees for the reverse exchange and the cost of the money need to make the acquisition prior to the sale. The arbitrage between CAP rates and the cost of money is nearly always favorable, otherwise we would not be in a seller’s market! Furthermore, depreciation deductions can be taken for the property not held by the QI during the reverse exchange period and there may be sig- nificant appreciation in the value of both properties during the exchange period. If it is possible to buy first, there are several other things to keep in mind: 1) cash that you supply to make the ac- quisition will usually be (par- tially) replaced immediately after the sale of the Old Prop- erty, which lowers the cost of money advanced to make the purchase, 2) contemporary reverse exchanges are often very well integrated with CRE lending processes, resulting in easier closings and in debt that is long-term and need not be mezzanine or bridge financing and 3) committed QIs are now deploying state-of-the-art re- verse exchange processes that subsume complexity for the exchanger, allow significant flexibility for pesky problems like environmental analyses and implement asset security devices that mitigate any rea- sonable risk of failure. The bottom line for many CRE investors is that in a forward exchange, significant income is being “left on the table” with no real compensat- ing benefits while in a reverse exchange, the ROI on the in- vested capital and other finan- cial benefits can be substantial and attractive while the com- plexity has plummeted. This is one of the facts about reverse exchanges that many QIs do not want exposed. The second article in our series will be
dedicated to a more detailed description of exchange ROI, the overall cost of exchanging and how these calculations can be done using all the relevant factors. Lastly, if you can’t sell or decide not to sell your Old Property after starting a re- verse, you simply keep both properties, meaning that you have no tax to pay because you haven’t sold anything. That is usually a more attractive out- come than that of a failed for- ward exchange. In addition, it is possible to extend a standard reverse exchange beyond 180 days should there be a delay in selling the Old Property. It’s neither simple nor cheap to do so but it is possible and may make sense if the problem is big enough. I’ll provide more detail on this extension tech- nique in a later article. Once a forward exchange has started, it is not possible to extend ei- ther deadline unless a natural disaster occurs. To summarize, the risks of using a forward exchange in today’s market are that 1) your exchange fails because you cannot identify and/or acquire New Property in time, 2) your equity is held by a QI for up to 180 days and generates no income for you and 3) if the exchange fails, you have to pay the tax on the gain from the Old Property sale and have no subsequent exchange options for that property. By contrast, using a reverse ex- change means that 1) you accomplish your investment objective first and then act as a seller in a seller’s market, 2) during a reverse, your capital is at work for you rather than the QI, potentially generating income and other financial benefits during the exchange period that you would other- wise not receive and 3) if the reverse fails, the two options are a) keep both properties and have no tax obligation because no Old Property has sold or b) extend the reverse beyond 180 days if the financial param- eters justify the incremental cost and effort. All things considered, the reverse exchange may be the informed CRE investors “se- cret weapon” for achieving advantages, both strategically and economically, in today’s challenging CRE market. Stan Freeman is presi- dent of Exchange Strate- gies Corporation. n
new one. But then, having sold your Re- l i nqu i s he d ( o r “ O l d ” ) Property, you now become a buyer in a seller’s mar- ket. Further-
Stan Freeman
denying a permit because the applicant refused to agree to a concession. The Supreme Court held that the Constitution can be violated in a permit denial case because the impermissible denial of a government benefit is a constitutionally cognizable injury. The Court also held that where “there is a direct link between the government’s demand and a specific parcel of property” the requirements of Nollan and Dolan apply and the exaction is held to a higher level of scrutiny. However, the Court did not answer what remedies are more, you may very well be a desperate buyer because you have 1031 exchange deadlines to satisfy! The 1031 statutes require you to identify poten- tial New Properties within 45 days of the close of the Old Property sale and to acquire one or more of the identified properties within 180 days. If you are unable to identify any properties within 45 days, your exchange has failed and the QI is required by statute to return your exchange proceeds immediately. If you identify one or more candidate New Properties and then are unable to acquire any of them, your exchange will fail and the QI is required by statute to keep your exchange proceeds until the 180-day exchange period has expired. Yes, even if you decide not to exchange on the 50th day, for example, if you have identified potential New Property, the QI must keep your money for the full 180 days. Of course, if you are able to successfully identify and acquire within the 1031 dead- lines, then the forward ex- change will work and the de- sired results will be achieved. However, in the current mar- ket, simply finding some num-
continued from page 2A The Supreme Court Helps Private Property . .
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