Tax-Deferral Strategies for Commercial Real Estate Owners

It was the best of times. It was the…best of times (sorry Dickens). With significantly raised values since the economic downturn of 2008-2009 and rents at record highs, many of our real estate clients seem to be in fantastic positions to capitalize on a truly fairytale moment for commercial property. In spite of, or perhaps because of, this strong showing, a growing number seem to be ready to cash in their chips.

We cannot say whether this indicates a peak in the market or frothiness in certain product types or geographic areas. Rather, our focus is to identify two tax-deferral strategies for owners of commercial property who seek alternatives to outright sales and prefer to remain invested in real estate, directly or indirectly. And so begins our tale of two transactions:

Tale #1: IRC §1031 Exchanges

The first strategy is the simpler one to discuss. In its basic form, Internal Revenue Code (IRC) Section (§)1031 allows real estate owners to exchange one piece of real property for another, without triggering capital gains recognition. By reinvesting in essentially the same type of enterprise, owners can defer tax on any gains and thus allocate their capital and resources more efficiently.

To prevent gains recognition, you must acquire “like-kind” property by 1) simultaneously swapping properties; 2) engaging in a deferred, non-simultaneous exchange; or 3) taking part in a reverse exchange.

The Essential Ingredient Is Timing

Your entire gain from a deferred exchange will be taxable if you fail to meet the following timeline. Countdown begins on the date you sell the relinquished property.

• 45 calendar days to identify potential replacement properties to your facilitator in writing.
• 180 calendar days to purchase and close the new property (or by the date of filing your next tax return, plus extensions, if earlier).

These two periods run concurrently, and there are no extensions for any reason, except for what the IRS terms a “federally declared disaster.” The timeline for simultaneous swaps also totals 180 calendar days.

Tale #2: A Different Animal Altogether

There are also transactions where owners can “exchange” their interest in real estate for ownership interest in a real estate investment trust (REIT)… kind of... mostly for owners of institutional-grade property.

This particular strategy is more complex and relies on the partnership rules, specifically IRC §721. These exchanges, often called UPREITs (short for “umbrella partnership real estate investment trusts”), provide an alternate exit strategy when you wish to get out of direct real estate management and still defer taxes. Instead of selling your property, you contribute it to an UPREIT in exchange for securities known as “operating partnership (OP) units” or “limited partnership (LP) units,” which are worth the same amount as the contributed property.

The Downside of UPREITS

Because you now own securities rather than the property itself, you can’t change course and move the exchange out of the UPREIT and into other real estate. The sale or disposition of your interest in an UPREIT will result in a taxable transaction, including the recognition of your deferred capital gain and any depreciation recapture. You can, if you wish, convert operating partnership units over time to spread out and lessen the tax impact.

In Sum, Focus on What Counts

Don’t allow the tax benefits of any transaction to outweigh the long-term strategic plans for your assets and family. While each of the transactions discussed have their risks as well as technical requirements, with careful planning and experienced support in place, either can potentially lead to economic rewards.

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Disclosures:
U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.

The information provided represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. This information is not intended to serve as a recommendation or solicitation for the purchase or sale of any particular product or service. It does not constitute advice and is issued without regard to any particular objective or the financial situation of any particular individual. These views are subject to change at any time based upon market or other conditions and are current as of the date indicated on these materials.