Trading up: Why land swaps can lead to big payoffs
The U.S. General Services Administration is on a mission. Since 2002, the agency that builds, maintains and otherwise manages federal properties has unloaded thousands of buildings in an effort to streamline its inventory and get rid of facilities that are underutilized, too small or just plain obsolete.
One way the agency has accomplished this goal is by trading unwanted properties for construction of new buildings or for upgrades on facilities they want to modernize and continue to use.
From the perspectives of both investors and the GSA, a swap of an old building in return for construction of a new one can be an efficient way to achieve both parties' goals, according to David Gorenberg, executive vice president of Riverside 1031, a company that represents buyers and sellers in tax-deferred 1031 property exchanges.
"The government views it as a wonderful thing because they didn't have to take on construction, and they get rid of old buildings, which they would have to be a landlord for," Gorenberg said.
In one example of these swaps, the developer builds the new facility, and the GSA buys it when it's completed. As compensation, he said, the GSA gives the developer an old building and most likely some cash to make up the difference. The developer or builder then has a new-to-them building that they can renovate — ideally with some cash they received as part of the building swap/construction deal — and can then sell or lease the higher-valued property.
Developers or builders can also benefit from a land swap deal if it's part of a 1031 exchange, a name which refers to the section of the Internal Revenue Service code that regulates these transactions.
Inside the 1031 exchange program
The IRS allows private investors to exchange properties on a tax-deferred basis as long as they follow a strict set of rules, according to attorney Rebecca Abrams Sarelson with Arnstein & Lehr in Miami. All transactions in a 1031 exchange must be conducted by a certified intermediary as well.
First, the property being bought or sold must be a commercial or investment property — no personal residences allowed. However, regular flippers of properties might find themselves with a huge tax bill when trying to take advantage of the 1031 program, as that activity could qualify those assets as "stock in trade" inventory, not an investment holding.
Then, the buyer only has 45 days after closing on the sale of the old property to identify a new property and 180 days to close on it.
There are also restrictions, according to Darryl Jacobs with Ginsberg Jacobs in Chicago, on the dollar amount of 1031-qualified properties in an exchange. The buyer is allowed to identify up to three properties of equal or greater value to the sold property and can buy one, two or all of them. If investors have their eye on more than three properties, they would still be able to identify them and then buy them all as long as their total fair market value doesn't exceed 200% of the fair market value of the old property.
If investors want to identify and purchase properties in excess of that 200%, then they must acquire at least 95% of the total fair market value of those properties.
As far as the type of purchases allowed, Sarelson said, as long as it's an investment or commercial holding, the options are wide open. For example, an investor can sell a commercial building and buy an apartment complex or sell a group of townhouses and buy a grouping of rental homes.
Interestingly, the 1031 program was initially instituted by the IRS to handle true swaps of properties equal in value that had no cash component. "I started practicing law in 1988," Jacobs said, "and I can count on one hand the number of those [types of] swaps." However, he added that these kinds of simple trades are more common between government agencies.
The 1031 transfer can figure into a GSA deal, Gorenberg noted, but only on the private side because the GSA isn't a taxpayer.
Investors can keep using the 1031 indefinitely. Sarelson said there are those real estate entrepreneurs who have spent a lifetime trading up through property exchanges and have never paid a dime in tax. As a reminder, she said, the 1031 program is tax-deferred, not tax-free. One slip-up in following the rules and all of those taxes that were put off can become due.
The time constraints of a 1031, however, might limit its use in the case of a lengthy construction project. Additionally, according to Gorenberg, if a developer takes a raw piece of land and develops it for the purpose of resale, that takes the possibility of using the 1031 program off the table.
Of course, if completed outside the scope of a 1031, private investors can conduct any kind of transfer they want to — with success — as long as both parties are adequately represented by real estate and legal professionals. Properties with mortgages create additional complications because both parties must obtain mortgages on the other. This is true for both 1031 and non-1031 deals.
Challenges for the GSA
The GSA doesn't have taxes as a consideration when it's executing an exchange transaction, and its sales and purchases don't have much in common with what investors usually think of when they hear the word "swap." But even federal agencies have setbacks.
Just this month, the General Service Administration pulled out of a "swap" deal to trade the existing Department of Labor Building for a brand new one to be built by one of three developers competing for the project.
The move was the result of a critical audit by the GSA's Inspector General, which found that the GSA had at least four failed exchange deals because it overvalued its properties and didn't always take the potential for necessary cash payments into full consideration.
The results of this audit reverberated through the GSA, which has also delayed the finalization of plans for the new FBI building, which also has a swap component.
So what makes a swap a good one? Obviously, both sides must be happy with both the property they received and the terms of the deal, and feel like they got at least somewhat of a bargain at the same time.
Swaps make sense, according to Jacobs, when both owners feel that their properties have lost their usefulness. "In the other guy's hands," he said, "they can become useful, performing and provide benefit."
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