Editorials

IRS 1031 Exchange: A Great Way To Get Out of San Francisco

Jan 28, 2019

 

 

Selling a Highly Appreciated Multifamily Building Could Trigger a Substantial Capital Gains Tax.  

 

As we look at the last 10 years leading up to the Proposition 10 vote on November 6th that could repeal the Costa Hawkins Rental Housing Act, there has been record appreciation for apartment owners in the San Francisco real estate market. It is not uncommon for owners to have tripled the value of their property in this time frame. Obviously, this is great news for owners. But with Prop 10 looming and the vote likely too close to call, many of our clients are looking for ways to get out of the SF market before the next inevitable attack on property owners. Will it be the major revision of Prop 13 that introduces a split tax roll, requiring apartment owners to have their property reassessed and taxed at the current full value? Maybe it will be a repeal of the Ellis Act. Either of them are the most likely candidates for a next wave attack here in San Francisco. It’s no surprise that owners are scared of the future of the real estate market in San Francisco and they are seriously considering their options. 

 

One option we’re seeing owners look at more and more is to sell their property, using a 1031 Exchange and converting it into the purchase of an NNN investment. My business partner Mason McDowell and I recently helped a client sell his rent-controlled apartment building in the Hayes Valley, do a 1031 exchange, and convert it into a net leased Apple- bee’s restaurant in Michigan. He had owned and cared for the apartment building for forty years. He and his wife planned to use the income for their retirement as well as providing supplemental income for his children. Throughout his long- term ownership, he enjoyed his fair share of late-night calls to be let in the building by tenants with lost keys. Once he even had a tenant who lit the place on fire, costing him thousands of dollars. 

 

As the owner aged, he started to question whether the hard work of owning and managing an apartment build- ing was practical for him (not to mention his kids having no interest in taking up the reins) and decided that as he looked to the future he preferred an investment that didn’t require such hands-on attention. 

 

He’s not alone. Many owners find themselves in this situation and are not sure what to do. That’s where we came in. With a little guidance from us, the client sold his SF apartment building and purchased the Applebee’s. This allowed him to increase his cash flow through a net, net, net (NNN) leased investment, plus he deferred his taxes on the gain through the magic of the 1031 Exchange. If it sounds too good to be true, believe me, it is not. 

 

Read on to see some frequently-asked questions and answers that explain how selling an apartment building, using the 1031 Exchange, and converting it into an NNN leased investment works. 

 

Q: What is an NNN leased investment? 

Also called Net Net Net and sometimes Triple Net, each of these terms refers to single tenant properties in which the owner has no responsibility for the operation or maintenance of the property. A typical example would be Walgreens drugstore or Starbucks. Tenants or lessees pay the rent to the landlord or lessor. The tenant pays all the other expenses directly which typically include property taxes, property insurance, and building maintenance. The Tenant takes care of all of the property expenses except the mort- gage (Net of taxes, Net of insurance, Net of building maintenance—NNN). 

Boot is the difference in price between the what an owner sells his property for and the cost of the new property in a 1031 Exchange. Think of selling property like climbing stairs. The down-leg is the property you are selling. The up-leg is the property you are buying. If the price of the new property is less than what you got for the old property, that’s considered boot and you will likely be taxed on the difference. As long as you buy the replacement property--the up-leg-- for the same price or higher, you will not have boot and you are allowed to defer the tax on the gain from your down-leg. That’s the goal when buying investment property. 

Q: What is 1031 ex- change “boot” and the best way to avoid it? 

 

Boot is the difference in price between the what an owner sells his property for and the cost of the new property in a 1031 Exchange. Think of selling property like climbing stairs. The down-leg is the property you are selling. The up-leg is the property you are buying. If the price of the new property is less than what you got for the old property, that’s considered boot and you will likely be taxed on the difference. As long as you buy the replacement property--the up-leg-- for the same price or higher, you will not have boot and you are allowed to defer the tax on the gain from your down-leg. That’s the goal when buying investment property. 

 

Q: What are the dead- lines owners must make to complete a successful 1031? 

 

There are two key dates: The first is the identification period, which means the client needs to identify which property they intend to buy within 45 days after the first close of escrow. The second is closing escrow on the replacement property, which must happen 180 days after the first close of escrow. The I.D. period moves very quickly. I have done two 1031 exchanges personally and I’ve found that after the 30th day without identifying a prospective property, I spent a lot of sleepless nights, worrying about making the deadline. In addition, we have helped numerous clients with their 1031 exchanges. With this combined experience, we have developed strategies that help sellers manage the deadlines in the process. 

 

Q: What is the best NNN to buy? 

 

That is the magic question. Much like fine art, it’s in the eye of the beholder. Typically, the higher the return on an NNN property the more risk in that in- vestment. The tenant could leave that location or even go out of business. Back in 2003, when I first started re- searching them, the best NNN investments were drugstores like Walgreens. They were opening everywhere. Today, retailers like Sears, Macys and Toys R US are faced with some tough competition from a little trillion-dollar company called Amazon. So, today we look for companies who don’t compete with Amazon very much. Companies that sell auto parts, discount clothing, restaurants, and even kidney dialysis are popular sectors. No one goes to Amazon to fix their brakes or see to their health. But you need to keep a continuous eye on the market. What works today, may not work tomorrow. 

 

Q: What is the best NNN lease length? 

The owners we have worked with generally look for at least 10 years left on the lease. Some prefer even longer leases. Short term leases have downsides and thus are often at a higher yield or cap rate due to the risk of releasing the space if the tenant chooses not to sign a new lease at the end of the term. 

 

Q: Should you have a lease guarantee? 

The best leases are guaranteed by the underlying corporation or a significant franchisee. Just like when you rent to a tenant who is a student or someone who has a bad credit rating, you ask for a parent guarantee or a co-signer. It’s good business to guarantee the lease. 

 

Q: What if my tenant moves out or goes out of business? 

It can happen and if so, the owner will need to find another tenant. A good example is Blockbuster Video. At one point there were over 4,500 Blockbuster stores in the U.S. Anyone older than 25 will remember these stores where you could rent VHS tapes and later DVDs. They were a very popular NNN investment. Unfortunately, that market died with the rise of Netflix and other streaming services. There are no real protections from a company that eventually leaves the space due to going out of business. However, if you look at the former Blockbuster on Ocean Avenue in San Francisco, it is now a CVS and the one on Bush at Leavenworth is now a popular gym. 

 

Companies that are considering a long-term lease for their stores often hire teams of people with MBA’s and many years of experience in analyzing demographics of income, traffic counts and pedestrian counts. If the location is a good spot with positive attributes and the tenant moves out, it’s very likely it will be appealing to the next evolution of retail. My favorite business school story is from the owner of Noah’s Bagels telling his real estate broker, “I do not have the money to hire all the MBA’s from Harvard and Stanford that Starbucks hires...go find me a spot 2 doors down from any Starbucks and I will locate there.” 

 

 

Q: What if we only find a property that is $50,000 less than we need for our 1031?

 

There are two options we recommend. If cash comes out of the sale at close of escrow, then it is considered Boot. Boot is taxable. The tax varies by your financial situation (please consult your CPA or Tax Attorney, as we are not licensed in this area), but all in it amounts to about 40% payment in taxes. These taxes are long term capital gains both state and federal, plus depreciation recapture. With the $50,000 above, that means after tax it would amount to approximately $30,000 net to the seller. For some sellers it’s easiest just to pay the taxes. The other option we recommend is a vehicle which is similar to a mutual fund of properties. These are called DST’s or Delaware Statutory Trusts. We like this for small increments of money, but not for the entire sale. 

 

Q: What’s the deal with “flexible” 1031 exchange accommodators? 

 

These are facilitators that ignore the law, which puts you at risk, by exceeding the 45-day deadline. This can result in in- validating the 1031 Exchange and incur a high amount of taxes (or unexpected taxes) and pricey penalties due. We do not utilize these facilitators with our clients because we would never advise an illegal strategy that would put our clients at risk (not to mention our real estate licenses). Think of it like speeding on the freeway: you might never get caught, but if you do, your “speeding ticket” in this case, might be a complete invalidation of your 1031 Exchange. In- stead, we have a strategy we call the “Accordion Close” that allows a seller to make a deal where he dictates a close of escrow date on his down-leg property, which effectively gives him more than the 45-day period to find a property. In one case, we were able to extend the timing from sale to selecting an up-leg property to almost 12 months. 

 

 

 

 

 

 

Written by: Terrence Jones, Senior Broker Associate, Alain Pinel Investment Group

E-mail: tjones@APR.com


Terrence specializes in the evaluation, sale, purchase and tax-deferred exchange of apartment and mixed use buildings in the Bay Area, with a focus on San Francisco.

His diverse experience in commercial brokerage, development, property management and construction helps make him uniquely qualified to provide highly professional consultation and brokerage services to the commercial investment community.Terrence personally manages apartment units and is the Managing Member for apartment investments in San Francisco.

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