There were several factors that collided from 2006 to 2008 like a perfect storm, which collectively caused the real estate bubble that eventually became a complete bust when the bubble burst. To understand what happened, and hopefully, to learn from it going forward, one would need to know how a 1031 tax-deferred exchange works in commercial real estate. Basically, the 1031 is a like-kind exchange that allows a seller to delay paying taxes on capital gains made in a sale by reinvesting the full amount of the sale into another property of equal or greater value. There are some other factors (such as depreciation and length of ownership) involved in the establishing qualification for tax deference, and the regulations are always changing over time, but in general, all of the money made on the sale must be reinvested in another property to avoid paying capital-gains taxes. For a simple example:
- An investor buys a property for $500,000 and owns it for at least a year.
- She sells it for $750,000 making the taxable gains around $250,000.
- She can avoid paying the taxes by reinvesting the entire $750,000 into another property.
It’s important to note that beginning on the closing date of the first property, the seller has 45 days to identify a second property for the exchange. The seller has six months to actually close on the identified exchange property, but the initial identification of the exchange property must be officially stated within 45 days to qualify for the tax deference.
Now, with these 1031 exchange requirements in mind, let’s look at a couple of key factors that fueled that real estate market bubble whose effects are still lingering with us today. First, a combination of low interest rates and banks’ extremely lenient lending policies made money readily available. Easy access to money meant that investors were buying and selling properties at an unprecedented rate. However, every time properties were sold the sellers would go looking for other properties of equal or greater value to buy to avoid paying the capital gains tax on the sold properties. This cycle gained momentum until the market resembled a feeding frenzy. As demand for a limited supply of higher-end properties skyrocketed, investors seemingly threw conventional wisdom and logical investment strategies out the door. The new investment strategy was simple … find an exchange property (any exchange property) to avoid paying capital gains tax at ALL COSTS – and in many cases, this was not a smart strategy. This motivation to avoid paying taxes created a snowball effect that drove the market up artificially and led to a lot of bad decisions that eventually backfired. Investors were buying properties without considering the fundamental factors that determine whether an investment is a good one. Many investors had paid so much for properties that the sell price was less than what they would have saved by simply paying the taxes on the previous property sale.
No matter what the market looks like, buying property is an ROI game that is always dependent on certain fundamental considerations, such as:
- How long has the owner held the property?
- What’s the adjusted basis on the property?
- What is the owner’s position as it relates to basis and taxes?
- What would the taxes actually be if a 1031 exchange was not made?
If investors haven’t compared the true value of a 1031 exchange investment versus waiting for a better investment opportunity (or price) and just paying the taxes, then they have not even done the bare minimum investment due diligence.
You may be wondering why I chose a topic that focuses mainly on issues of the past. Well, I’m a believer in the cliché that history repeats itself – especially if we don’t learn our lessons. I’m not saying that another bubble is forming or that the same feeding frenzy is on its way, but as the market continues to recover and improve, the potential for a repeat is certainly possible. We’re already seeing some of the same early signs in the greater Wilmington area. For one, good properties are becoming somewhat scarce.
So, here’s the bottom line – the lesson we can learn from our past. Do not let avoiding taxes be your one and only basis for making buying decisions. Base your decisions off the fundamentals. Look at the whole picture, and if you don’t have the expertise to know what the whole picture looks like and which questions to ask, then find a professional that does. You just might discover that sometimes paying taxes is the best decision.
Grayson Powell is a Managing Partner at Coldwell Banker Commercial Sun Coast Partners (CBCSCP). CBCSCP leverages the vast experience of highly-skilled real estate professionals and developers and specialize in selling, leasing and managing retail, commercial, and investment property. To learn more about CBCSCP, visit www.cbcwilmington.com or call 910-350-1200.
