Sanjeev Misra Writes on the 1031 Exchange Process for AAHOA Lodging Business
07/03/07 21:19 Filed in: Guide
FOR IMMEDIATE RELEASE:
Sanjeev Misra Writes on the 1031 Exchange Process for AAHOA Lodging Business
1031 Exchange Process
The what, why and how of using the 1031 Exchange structure.
Success fuels success. The lodging industry set new performance records in 2006 and this is evidenced by the amount of new capital that entered our industry sector. This led to more hotel assets changing hands then ever before.
Many of the transactions today involve buyers seeking to take advantage of a provision in the tax code that allows an investor to defer capital gains taxes from a sale if they immediately invest in a comparable asset. They are commonly referred to as “1031 buyers,” the name derived from Section 1031 of the Internal Revenue Service Code, which outlines the rules for the like-kind exchanges. And while many of the buyers seeking hotel assets are new players drawn to the hotel industry by attractive yields, as a hotel owner, you should understand how you, too, can benefit. Hopefully, this article will help you understand one of the best-kept secrets in the IRS Code, the meaning of this code, the benefits, when to utilize it, and most importantly, how to complete a 1031 Exchange.
First, you really need to know what a 1031 Exchange is. A 1031 Exchange allows a real property owner to sell real property and reinvest the proceeds into another like-kind property and defer the capital gains taxes. The term ‘like-kind’ means that the property sold must be held for productive use in trade or business or investment and the property acquired must also be used in the same manner. You can trade apartment buildings, office buildings, raw land and other income producing assets for hotels. You can also trade your hotel for any of these asset types. You cannot trade with non-revenue generating assets such as your primary residence, stocks bonds or partnership interests.
The main benefit of an exchange is deferring paying taxes on capital gains. Everyone has to pay “Uncle Sam,” but if we can pay him tomorrow instead of today, we can invest that deferred tax payment to generate investment return. Think of the exchange as an interest-free, no-term loan from the government. People also look at the 1031 Exchange as a way to increase money available to leverage into larger real estate holdings. For example, a $1 million capital gain, invested at a loan-to-value ratio of 80 percent can be used to acquire an additional $5 million in real estate.
There are specific instances in which a 1031 Exchange should be considered. If you are planning to sell a real estate asset at a price that will net a gain upon sale, then you should consider an exchange.
There are several strategic reasons for utilizing this structure:
• Increase leverage
• Upgrade or consolidate property
• Diversify (either geographically, by brand or divide into multiple properties)
• Relocate to new areas
• Take advantage of differences in regional growth
• Change property types (from residential to hotel)
To complete an exchange you must follow the 1031 exchange rules. The first rule is that the exchange is ‘like-kind’ as mentioned earlier. Keep in mind that ‘like-kind’ is broadly defined. For example, you can sell a retail property and buy an office building or a hotel, as both are properties. Second, the proceeds from the sale must pass through a qualified third-party intermediary. If this is not done, the proceeds become taxable. Third, all cash proceeds from the original sale must be reinvested in the replacement property. Finally, the replacement property must have an equal or greater level of debt than the relinquished property or the buyer will have to place more cash funds into the asset to offset the lower debt, or pay taxes on the difference.
There are four basic types of exchange:
1) Simultaneous Exchange: the closing of the relinquished property and replacement property occur at the same time, back-to-back.
2) Delayed Exchange: the replacement property is closed on at a later date than the closing of the relinquished property.
3) Reverse Exchange: The replacement property is purchased and closed on before the relinquished property is sold.
4) Improvement Exchange: The taxpayer desires to acquire property and complete construction or improvements on the property before it is received as a replacement property.
Now, I will walk you through the process of completing an exchange. The most common exchange in our industry is the Delayed Exchange. In this scenario, let’s say a big REIT approaches you that wants to purchase your hotel and offers a price that is too good to turn down. Let’s say you are selling an independent hotel you bought for $4 million, renovated for $1million and are now selling for $6 million. After making the decision to sell, you realize that you will have a large capital gain and thus tax liability. You decide you want to complete an exchange. It may be helpful to first calculate potential capital gains tax liability before you decide to do an exchange. Although this is best left to your accountant for exact numbers, you can easily do a quick analysis if you have access to your balance sheet and know your capital gains tax rate. To assist you in these, let’s examine a hypothetical exchange. There are three steps:
Therefore, in this example transaction, you could defer roughly half a million dollars in tax liability. If you can invest that money at a 10 percent return rate, you are generating $50,000 annually off your “interest-free government loan.”
Now that you understand the dollar value to utilize an exchange structure, you must go through the exchange process. First, you must identify a good Exchange intermediary and attorney that will guide and support you through the process. Second, in your contract to sell your hotel, have your attorney place accommodating language that states that the buyer will work with you on timing to accommodate your exchange requirements. You must have entered into a “Qualified Exchange Accommodation Agreement” between you and your intermediary within five days of the title transfer of your hotel. Now comes the exciting step: the Identification Rule. You will have 45 days from the sale of your asset to identify a replacement property and notify the intermediary of the real property with the legal description. There are several conditions under which more than one property can be identified and your lawyer can explain these options to you. After the identification stage, you have 180 days to complete the acquisition of the replacement property. That is the basic process in completing a 1031 Exchange.
We have utilized this structure in deals from small single hotel assets to hotel portfolios. Along the way, we have come across some lessons that I would like to share with you. Keep these in mind while you go through your process:
1. You are using a 1031 Exchange because you want to buy a replacement asset, not the other way around!
Recently, while working on a deal, we were rapidly approaching our deadline to identify a hotel for a 1031 Exchange. We were under so much pressure to meet the exchange deadline, we were constantly adjusting the pro-forma and making more positive assumptions than we should have to make the deal underwrite. We finally realized we were trying so hard to find a replacement asset to save taxes that we were compromising our underwriting standards. We ended up walking away from the deal and not using an exchange. Remember, using an exchange to save taxes does not help you if you end up buying an inferior asset to “beat the deadline.”
2. Explore Tenants-in-Common (TIC) Structures
Tenants-in-Common (TIC) is a form of real estate ownership in which multiple parties have an undivided, fractional interest in the asset. Through TIC ownership structure, you can enjoy ownership in an institutional-type property with a minimum investment. This structure can get you into a hotel asset class that you may not have been able to purchase through your own abilities. You can also utilize TIC successfully to create joint ventures and partnerships or passively invest your proceeds with a partner that will handle the stress of managing the hotel.
3. Create a Exchange Timeline with Deadlines
Make sure you give yourself adequate time to go through all the hotel transaction related requirements to meet an exchange deadline. Many times we have been successful in getting a hotel under contract with the buyer and seller ready to close, only to be held up waiting for lender closing, franchise approval or other items that must be secured before closing. Create a timeline with your attorney showing when items are due and determining who is responsible for completing these items.
4. 1031 Exchange evaluation should be a part of every hotel sale
You should always consider your tax implications and the ability to utilize an exchange when selling an asset. It is not just a financial decision, it is a strategic decision. As mentioned earlier, every time you sell a hotel, you are adjusting your hotel portfolio risk and diversification. Use the opportunity to determine strategically where you want to take your company. You should always ask if you are in the right market segment, hotel brand, location, number of rooms and risk profile for where you want to grow your company.