NestEgg Investing: 1031 Tenants in Common Exchanges

1031 TIC Exchange Service Provider Feedback Project

[Update]: We've recently launched a directory site www.1031reviews.com that provides a more comprehensive list of 1031 registered reps, QIDs, and sponsors by state and city.  We're also adding reviews and ratings, so you can vet folks before working with them.

In choosing which 1031 firm to work with, there's nothing more valuable than feedback from a prior investor.  I get emails from readers all the time asking my opinion on specific 1031 firms.

To address this need, I was considering creating an "Epinions" (link) site to rate 1031 exchange service providers: 1031 tenants in common syndicators, 1031 exchange intermediaries, 1031 qualified intermediaries, etc.  Before investing the cash to develop such a site, I wanted to get feedback from readers to make sure people would find it valuable and would contribute their feedback to the site. If you would like me to invest in such a site, please either post a comment, or email me at http://www.the1031ticexchange.com. 

Researching a 1031 TIC Exchange Firm Part 3

Continued from previous post (link)

7) Has the firm ever been sued? 

8) Has the firm ever had to make a capital call?  If the firm has had to make a capital call, that means the firm used too much leverage, did not manage the property well enough, or made a similiar mistake.

9) How do I get out?  A life event may force you to have liquidate your ownership share earlier than you intended.  You should get in writing the process for selling down your ownership. In highly leverage buildings (70% debt), often the loan document must be amended and the new buyer approved by the bank.  This will incur significant fees in addition to the decrease in selling price do to your distressed situation.  Some firms won't let you get out at all.  More generally, have a firm layout in black and white exactly the restrictions (both legal and practical) you will face if you need to sell

10) Talk to prior investors: If you do anything at all, talk to private investors about their experience.  If you can find someone not referred by the 1031 firm, all the better.  It will give you confidence that the firm you are working with is legitimate. Please also help others in this regard. If you have performed a 1031 exchange of any kind (traditional, TIC, etc.) and have feedback--good, bad, or indifferent-- on any the firms that you've worked with, please email us with feedback: nesteggemail@gmail.com

Continued at Researching a 1031 Firm Part 4 (link)

Researching a 1031 TIC Exchange Firm Part 2

Continued from previous post (link)

4) Fee Structure:  Have a 1031 syndicator layout on paper their entire fee structure.  Many times they will list the fees as a percentage of assets rather than a percentage of equity.  For example, a large firm quoted us fees of 10% of the asset purchased which sounded reasonable.  However, when you consider that the building was being purchased with 50% debt, the fees equated to 20% of equity exchanged which is higher than the national capital gains tax.

5) Underwriting Leverage:  From what we've seen, 1031 syndicators underwrite their purchases from 0% debt all the way up to 80% debt.  Obviously, the lower the debt, the less risky.  We generally think that around 50% debt makes sense.  With higher debt levels, there's greater chance that firm will not be able to cover debt service and deliver their guaranteed return.  Even worse, they are not able to cover debts service and will make a capital call which requires you to put more money in.

Finally, the greater the debt, the more restrictions the banks will have on the investors.  Thus, they may have restrictive covenants that prevent you to sell down your portion, etc.

Also pay attention to how this debt is structured.  Many firms will use interest only debt in the early years.  They do this to increase their yield to investors at the cost of big principle payments and lower returns (and potentially capital calls) in the future.

6) Debt Available to You:  When you do a 1031 exchange you need to rollover both your equity and your debt.  Most firms will provide loans for you.  This is helpful, as raising debt on your own can be difficult for a fractional ownership of a building.  Be careful about how these loans are secured. Many firms will over non-recourse loans which are secured by ownership in the building itself rather than your personal assets.

Diligence List Continued (Link)

1031 TIC Exchange Firm Due Diligence List

The 1031 industry is in some ways brand new.  As a result, it's pretty difficult to determine which firm you can trust.  To help sort through the wheat from chaff, we've put together a "due diligence list" below to help you more rigorously research firms to work with.  As always, consult your tax and financial advisors.

To better serve you, we're looking to launch a feedback project on 1031 service providers (find out more link) .  If you think this would be valuable, please post  comment or email us at nesteggemail@gmail.com

1) Firm background: Find out how long your 1031 syndicator has been in business, how many transactions they have performed, and how credible the leadership of the firm looks.  Many firms have grown out or are subsidiaries of title or brokerage companies.  So be careful about differentiation between the track record of the 1031 company and the parent company.

2) Offering:  First take a look at what type of offering (Tenants in Common, Tenants in Common Triplenet Leases, UpREIT). Generally, we feel that the UPREIT still has not been approved by the IRS and is thus more risky.  Second, look at the properties themselves:  research the geography, the tenants, and the general quality of the assets.  Finally, how big is their property portfolio.  The bigger usually will indicate a larger and more established firm.  Also, when you go to exchange it's more likely that they will have a property available.

3) Promised Return:  Be careful about exactly what return the firm is promising.  Some firms advertise "cash on cash yields"  which are really returns to your equity.  Others advertise capitalization rates which are returns to equity and debt. 

Diligence List Continued (Link)

Choosing the Right 1031 TIC Syndicator or Exchange Firm

Six months into our research, we do think that the new options available under the loosened 1031 law can very powerful vehicles for personal investors.  We've talked about this in the prior posts, but these new 1031 options allow investors to diversify geographically, to eliminate management (through exchanging into triple net leases), to increase yields (particularly if you are exchanging away from the low cap rate geographies like the Bay Area), and to reduce principal and tenant risk (if you are exchanging into institutional properties). 

That's great in theory, but how does play out where the rubber hits the road?  We're beginning to research actual firms that provide 1031 exchange options and our advice is be careful and really do your homework.  This is a new industry, and while there are some reputable firms, we've certainly found plenty of fly-night operations. 

To help you do your homework, we've created (and will update as we continue to do our research) a diligence list of good questions to answer before working with a 1031 syndicator.  As always, consult your financial and tax advisor.

Firm Due Diligence Checklist Link

Please also help us with this effort.  We're looking to launch a feedback project (find out more link) on 1031 service providers.  If you think this would be valuable, please post  comment or email us at nesteggemail@gmail.com. 

1031 TIC Exchange Triple Net Leases, The Management Free Option

An increasingly popular 1031 exchange option is the triple net lease  (ie. "NNN").  A triple net lease is a long term lease where the tenant pays for all maintenance, taxes, insurance, and utilities.  Usually, these NNN leases are with well know franchises or chain stores such as Walmart, Walgreens, Pizza Hut, and Starbucks. 

The advantages of exchanging your investment property (either individually or through a tenants in common) into a NNN property are:

1) Zero maintenance

2) Zero occupancy risk- high credit tenants sign long term leases

3) Lower principal risk (because of #2)

4) If you purchase through a tenants in common structure, you can buy a larger, and thus higher yielding property

The attached article provides a good overview: article link

What You Can and Can't Do In a 1031 TIC Exchange

As always, check with your tax advisor, but here is what our research suggests is possible under 1031 tax laws.  Some of these options are highly sensitive to IRS rulings.  If we hear of more information, we'll post it on this blog.

Download cancant_do_1031.pdf 

How to Complete a 1031 Exchange

The 1031 tax code allows you to roll-over capital gains from the sale of one building into the purchase of a new property on a tax deferred basis. 

The step by step process is as follows:

1. Consult with your CPA, financial planner, attorney or other advisor to determine if you would benefit from a §1031 exchange.

Disposing of Your Relinquished Property

2. Instruct your real estate agent or attorney to insert a clause into the Purchase and Sale Contract requiring the buyer to cooperate with the exchange process.

3. Inform your escrow officer or closing professional that you will be engaging in a §1031 exchange.

4. Contact a Qualified Intermediary (QI) to open your exchange. Provide the QI with the following information:

a. Your name, address, telephone and fax numbers, e-mail address and taxpayer’s tax identification number;
b. Sales price of the property;
c. Amount of third-party debt or seller carry-back financing;
d. Escrow or closing agent’s or attorney’s name, telephone and fax numbers, e-mail address and file number;
e. Copy of the Purchase and Sale Contract
f. Copy of the Preliminary Title Report or Commitment for Title Insurance;
g. Copy of the Escrow Instructions (if available).

5. Execute an Exchange Agreement with the QI.

6. Execute an Assignment, Acceptance and Notice Agreement transferring your rights under the Purchase and Sale Contract and the Escrow Instructions to the QI and notifying all parties to the transaction of the assignment.

7. Execute a Qualified Escrow Account Agreement with the QI and its affiliate title  insurance company. This segregated Qualified Escrow Account safeguards your exchange funds from any liens from our creditors.

8. Inform the QI of the progress of your transaction. At the closing, your escrow or  closing agent will disburse any net equity from the relinquished property to your segregated Qualified Escrow Account and transfer the title directly to the buyer. The QI will notify you in writing when the QI receives your exchange proceeds. The QI will deposit your funds in a segregated Qualified Escrow Account with its affiliate, title  insurance company. The title insurance company will invest your funds in a secure, liquid investment vehicle where your principal will not fluctuate and you will earn a competitive interest rate. You will receive monthly statements on this account.

Identifying Potential Replacement Property

9. Mail, fax or hand deliver a signed description of your identified properties to the QI within 45 calendar days after the transfer of the title of your relinquished property. When  identifying your replacement property, you must comply with one of two identification rules.

3-Property Identification Rule
You may identify up to 3 potential replacement properties without regard to value.

Or

200%-Property Identification Rule

You may identify more than 3 potential replacement properties as long as the total fair market value of your identified properties does not exceed 200% of the fair market value of your relinquished property. If the fair market value of your identified properties exceeds the 200% rule, then you must purchase 95% of the aggregate fair market value of your identified properties (excluding any revoked identified properties).

You may revoke a property identification at any time during the 45-calendar-day period and identify new potential replacement properties. New identifications and revocations must be in writing. Any property that is acquired during the 45-calendar-day period is considered to have been identified.

Acquiring Your Replacement Property

10. Select and close on one or more of your identified replacement properties on or  before the earlier of the following dates: a) 180 calendar days after the transfer of the title of your first relinquished property; or b) the due date of the tax return (including filing extensions) for the year in which your relinquished property closes.

11. Defer all capital gain on your transaction by purchasing property that is equal to or greater in value than your relinquished property; reinvest all of the net equity from your relinquished property in the replacement property; and acquire debt on the replacement property that is equal to or greater than the debt on your relinquished property. You may also complete a partial exchange. You will incur tax liability on the non-qualifying portion.

12. Instruct your real estate agent or attorney to insert a clause into the Purchase and Sale Contract, requiring the seller to cooperate with the exchange.

13. Contact your escrow or other closing professional to arrange for the closing of your replacement property.

14. Inform your exchange administrator at the QI that you are closing on your replacement property. Provide the QI with your closing information.

15. Execute an Assignment, Acceptance and Notice Agreement transferring your rights under the Purchase and Sale Contract and the Escrow Instructions to Diversified Exchange Corporation and notifying all parties to the transaction of the assignment.

16. Keep in close contact with your exchange administrator at the QI until the replacement property closes and the funds are wired. The exchange administrator will disburse the net equity from your relinquished property to the escrow or closing agent’s account. The escrow or closing agent will disburse funds to the seller, who will transfer the title directly to you, the buyer.

Receiving Your Exchange Funds

You may have access to your exchange funds when you have met one of the following conditions:
-You have purchased all of your replacement property and your identification period has elapsed; or
-You have failed to identify any replacement property within the 45-calendar-day period; or
-Your 180-calendar-day exchange period has expired; or
-A material and substantial contingency has occurred after the end of the identification period that:
1) relates to the exchange
2) is provided for in writing
3) is beyond the control of you or a disqualified person.

The Internal Revenue Service requires the QI to strictly adhere to the above criteria.

1031 TIC Exchange Overview

The biggest driver in real estate investing is the IRS 1031 tax code, but what I realized after doing a year’s worth of research is that there is a lot of misinformation out there. I've tried to fill the gap with this website.  I've given an overview of the core 1031 exchange tax law and its strengths and weaknesses.  More interestingly, I've outlined the new IRS rulings on 1031 exchanges which allow some great new options for the real estate investor. 

The Gist of a 1031 Exchange

The 1031 tax code allows you to roll-over capital gains from the sale of one building into the purchase of a new property on a tax deferred basis.   When employed correctly, it's a powerful tax code that allows investors to move into larger and larger investment properties while locking-in capital gains and increasing rental income.  However, these 1031 exchanges particularly in the Bay Area have led to very poor investment decisions.  Personal investors have 45 days to identify and 180 days to close on a new property.  If an investor fails to perform a roll-over transaction, he is hit with a large capital gains tax bill.  As result, as the days start ticking down investors are just looking for any building to roll into.  I know that commercial broker's best clients are 1031 exchangers who are under the gun to find a new property in time.  Further, for investors approaching retirement who have rolled into bigger and bigger properties (eg. from a duplex, to a 4-plex, to an 8-plex), these exchanges lead to bigger and bigger management headaches.

Here's a summary of the basic law: Download 103120summary.pdf  as well as a link to how to complete a 1031 exchange transaction:  1031 Exchange Transaction Link

New Options

In 2002 the IRS tax code loosened significantly and allowed some new powerful tax strategies.  There's a variety of new options available to the real estate investor (What You Can and Can't Do Under 1031 Link).  Here's some examples:

 

-Retire, end your property management pains while increasing your cashflow:  Retirement Link

 

-Defer gains above $500K on the sale of your primary residence: Primary Home Link

 

-Exchange your rental property for a fractional ownership of a larger institutional- grade property that yields higher returns, zero management, higher tenant credit quality:  TIC link

 

-Set up a zero-tax estate plan:  Estate link

 

-Exchange investment property into a REIT: Link to REITS

Where the Rubber Hits the Road: Choosing the Right 1031 Firm If after you've read all the pros and cons we've listed, and you want to look into 1031 exchanges more deeply, we've create a guide to how to research and pick a firm that you can trust:  How to Choose the Right Firm (Link)

What You Can and Can't Do Under 1031 Here's a two page write up on the ins and outs of the 1031 law:  What You Can and Can't Do (Link)

How to Complete a 1031 Transaction Here's an overview of the 1031 exchange process.:  How to Complete a 1031 Transaction (Link)