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1031 Investors Begging For Relief From Tight Deadlines Amid Pandemic

The IRS is looking at delaying deadlines for like-kind exchanges for real estate sales as the industry struggles to function during the coronavirus pandemic.

One of the IRS welcome signs at its Washington, D.C. headquarters.

Like-kind exchanges, also called 1031 exchanges, allow real estate investors to sell one asset — assets like condominiums to warehouses to office buildings — and buy a similar asset within 180 days. In doing so, those investors can avoid paying capital gains taxes to the IRS.

"The IRS is considering a wide range of COVID-19 relief, but nothing has been released at this time," IRS spokesperson Eric Smith said. When asked if the IRS was considering changes to 1031 exchange deadlines, Smith said, "That could be addressed."

More than a third of all property sales use 1031 exchanges, which means potentially thousands of investors who sold properties in late 2019 are under the gun to buy something soon to avoid capital gains taxes, unless the IRS extends the deadline.

As of press time, neither the Treasury Department nor the IRS has issued any new guidance on like-kind real estate exchanges. 

“It's a real stressful situation because the clock is ticking. These are the holes in the dike that need to be plugged,” CCIM Institute Chief Economist Kiernan “KC” Conway said. “It's hope and faith right now. It's nothing else.”

Shelter-in-place orders have shuttered businesses and governmental entities critical to real estate transactions. At the same time, determining real estate values has become nearly impossible in the near-term as landlords face a slew of commercial tenants seeking rent abatements or not paying rent at all.

Lenders have waited to go forward with deals until the uncertainty abates, but 1031 buyers can't afford to wait.

“We're going to our sellers and saying, 'Guess what? We need more time.' That's what's happening all over real estate. Everybody's asking for more time,” said Steve Rothschild, a partner with The Strategic Group, which operates 1031 exchanges and opportunity zone funds. “But if you're up against your deadline, you got to make your decision.”

The Strategic Group partner Steve Rothschild

This quagmire has led some of CRE's leading organizations — including the Associated General Contractors of America, The Real Estate Roundtable, the Building Owners and Managers Association, the National Multifamily Housing Council, the International Council of Shopping Centers, NAIOP and NAREIT — to petition U.S. Treasury Secretary Steven Mnuchin to extend the deadlines by which investors can purchase replacement properties for recent sales.

The move could add 120 days to sellers' 45-day deadline to identify a 1031 acquisition target and the last day to close on that property. The IRS has allowed similar delays in the past through disaster declarations in certain geographic locations that have experienced natural disasters or emergencies.

“Unfortunately, current circumstances make compliance with like-kind exchange reinvestment rules impossible,” the parties wrote in the March 23 letter to Mnuchin. "Identifying properties for trade purposes requires travel and a confidence in both the expected cash-flow stream and the value of potentially acquired property. Closing on an identified property requires these same conditions plus extensive due diligence by the buyer, lender, and other third-party contractors. All of these necessary steps are currently unfeasible due to travel restrictions, quarantine, properties being locked down, and office closures of title/escrow companies and governmental recording offices."

The coronavirus has forced the closure of many retailers.

The pandemic has upended the values of commercial real estate, impairing lenders' ability to underwrite deals, Investment Property Exchange Services Inc. General Counsel Suzanne Goldstein Baker said. Baker is also the co-chair of the government relations committee of the Federation of Exchange Accommodators.

“The coronavirus ... really complicated every kind of business in the United States and everyone's lives,” Baker said. "That's sort of the understatement of the year."

The hangover from uncertain real estate values will likely drag on beyond when the pandemic has abated and public spaces reopen, Avison Young principal Casey Keitchen said. And some investors will be reluctant to buy real estate and instead hold on to capital until the market bottoms.

“Cash is back to being king,” he said. "It's not how much debt you can get and what the terms are. It's kind of wait-and-see. Everybody's hoarding cash right now ... hoping for an opportunity here."

In the realm of commercial real estate investments, like-kind exchange investors tend to be smaller investors rather than institutional firms with millions and millions in capital behind them, experts say. Current data is difficult to come by, but a 2015 National Association of Realtors survey found that 39% of all real estate sales volume involved like-kind exchanges.

But unlike with trophy building sales or major distribution center trades, the average fair market value for properties sold in 1031 exchanges was $7M, according to NAR. NAR officials did not have any updated data.

Professional motivational speaker Michael Levin, who also invests in 1031 exchanges.

Baker echoed those findings, saying the median value of properties traded by exchanges in the country was $500K or less. For well-heeled investors or institutional firms, the capital gains tax penalty is nominal. Not so for others.

“If it's your tax bill and you're a smaller investor … and you have a couple hundred thousand dollar gain … that's a big bill,” Baker said. “The beauty of Section 1031 is that it's available and used by a broad spectrum of taxpayers. For every trophy building in a major city, think of how many small rental homes, rental condominiums, flats and small auto body shops there are across the country at such a lower value. Those kinds of properties are very frequently the subject of 1031 exchanges.”

The real estate organization's letter to Mnuchin echoed that sentiment.

“Taxpayers, many of whom are small and medium-sized businesses and middle-class investors, should not have to be concerned about the possibility of having to pay significant capital gains taxes because like-kind exchange transactions cannot be completed due to the disruption caused by the coronavirus pandemic," the letter says. "The funds they would have to utilize to meet such tax obligations would only further reduce liquidity in real estate markets.”

Michael Levin is one of those investors. A motivational speaker by trade, Levin invests in residential and small multifamily properties to buffer his future retirement, he said. Levin is now racing to close on small apartment buildings in Syracuse, New York, after selling rental homes in suburban Atlanta and Charlotte, North Carolina, at the start of the year. 

Levin negotiated the purchase of a duplex in Syracuse for $133K as the coronavirus was a blip on the news radar. He plans to close his purchase on April 15, despite all the difficulties in the process and concerns that investors buying real estate today may be overpaying. Levin said he already closed the purchases on the rest of his small Syracuse portfolio.

“Candidly, the purchase price is not that material. What's my ROI on the property,” said Levin, who is buying the duplex in cash. “If I was trying to deal with loans at the same time now, I don't know how that would be — considering it was difficult under normal circumstances."

Levin may be one of the lucky ones to actually execute a 1031 exchange on a property during this time.

New guidance by the IRS and the Treasury Department may likely be the only fix for real estate investors, especially with politics clouding Congress' ability to get much done, Conway said. Conway said he does not expect the like-kind exchange issue to be addressed in any follow-up stimulus bill.

“Unfortunately, here's the reality: When you look at the scheme and sequence of things that need attention, my fear is that there's a lot of people in Congress who see this and, well, [they believe] that's just a lot of rich people who want to get out of taxes,” he said. “[But] it isn't a bunch of rich Americans with a lot of cash sitting around.”

Keitchen said, for one of his exchange clients, the partnership decided to just pay the capital gains tax instead of buying a property by the deadline, which could wind up being an overpay.

Baker said her firm is advising clients to go ahead and hold out on deals under the belief that the IRS will eventually extend those deadlines.

“Hang in there because if guidance comes, they could find themselves in a good position,” she said. “It could be a buyer's market. I don't have a crystal ball, but that's certainly possible with what's going on.”