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How a Tax Benefit for Developers Could Backfire in the Pandemic

commercial real estate market: Investors may end up losing millions in tax savings on gains from the sale of their properties because of the coronavirus pandemic.

Like-kind real estate exchanges, also known as 1031 exchanges (after the provision in the Internal Revenue Code), allow investors to sell a commercial property and pay no tax on the gains as long as the money from that sale is reinvested in other real estate. It could be a similar building, land or even air rights.

The provision was preserved in the overhaul of the tax code that was signed in 2017 by President Trump, who made his wealth in real estate development, while investments in other areas, like art and classic cars, were stripped of their special tax status.

To reap the benefit, real estate investors need to identify a replacement property 45 days after the sale of the original property and close on the purchase within 180 days. If the criteria are met, the investors can defer taxes on the gains from the sale of the property. The deferral can extend until the investor’s death, at which point the capital gains tax is wiped out.

If the criteria are not met, the investors face not only an enormous tax bill for the gains but additional taxes for deductions taken while they owned the building. That can amount to millions of dollars for some properties.

As lockdowns complicated closing deals, the real estate industry lobbied the Treasury Department to get extensions on those dates, and it obliged in early April. The department said that if either the 45- or 180-day deadline fell between April 1 and July 14, it would be moved to July 15 — the new deadline, too, for filing income and other federal taxes for 2019 and the first half of 2020.

But the guidance lacked clarity on some key issues underlying disaster relief for like-kind exchanges, and the extension could do more harm than good to certain sectors of the commercial real estate market, like retailing and entertainment, that are already under economic pressure.

The extension of the deadlines for like-kind exchanges has resulted in sales being postponed or canceled, purchase prices being reassessed and money from a sale staying out of reach of the property investor who might need it.

“Usually, you think tax extensions are a favor to taxpayers,” said Kate Kraus, a partner at the law firm Allen Matkins in Los Angeles. This one “is all murky,” she said, adding: “The government seems not to have thought about the consequences of this.”

The extension started like many others, with an interest group writing a letter asking for relief. In this case, the Real Estate Roundtable wrote to Steven Mnuchin, the Treasury secretary, who granted the request.

“It seemed like a good-government, reasonable thing to do,” said Ryan McCormick, senior vice president and counsel at the group.

Investors had already started the process of the exchange, he said, but it became difficult to travel because of pandemic lockdowns, and they were unable to do due diligence like an appraisal. “Taxpayers were seeking some additional time to work through that,” he said.

But once the relief was granted, deals that were part of 1031 exchanges began to fall apart.

Jatin Desai, chief financial officer and chief investment officer of Peachtree Hotel Group in Atlanta and a member of Tiger 21, a group of ultra-high-net-worth investors, said he had been approached before the pandemic to sell one of the company’s hotels in South Florida. The two sides reached a deal, which was set to close before the July 15 deadline.

“When we found out it was a 1031 buyer, we thought they’d close quickly,” he said. “But when the deadline was pushed out, the buyers said they were going to push out the closing.”

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The deal had a 90 percent chance of closing before, he said, but he gave it a 10 percent chance now.

Nationally, smaller real estate exchanges — worth less than $3 million — have come to a halt, and larger ones are being delayed, said Alex Madden, vice president of Kay Properties and Investments, an online marketplace for 1031 exchanges.

He said the number of properties for sale nationally was down by 75 percent since mid-March. The ones that remain attractive are properties that he called “coronavirus resistant,” like drugstores and distribution facilities that serve companies like Amazon or FedEx.

Investors taking advantage of exchanges are expected to treat July 15 as their date to identify or close on a property. But if that date holds, it could create artificially inflated prices for those few “coronavirus resistant” properties.

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Credit…Lori Krenzen

Jay D. Stein, president of the Scottsdale, Ariz., office of Sandor Development, which invests in strip malls and free-standing drugstores, had a group of buyers signed up for four of his CVS stores that pulled out when the extension was passed. But he is optimistic that the new deadline and the continued uncertainty around commercial real estate could benefit him.

“It’s very possible you can see the best product get into bidding wars, in early to mid-July,” Mr. Stein said. “Everyone is chasing the same stuff — high-credit quality properties with good cash flow.”

Investors face other challenges in completing these deals, including financing. Buyers who need a mortgage could struggle to get bank financing because of falling property values or pay more for loans from private lenders. Mr. Stein said he had sold his CVS stores with the debt in place to save the buyer from having to obtain debt financing.

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Because the value of some properties has fallen in the pandemic, buyers who entered a contract on a property as part of an exchange do not want to pay the price they agreed to before the crisis hit.

“This replacement property now has tenants who are no longer paying rent — WeWork-type tenants, restaurants, tenants who may be going out of business,” Ms. Kraus said. “It’s a mess that you can’t clean up quickly.”

Because some properties no longer make economic sense to buy, she has advised her clients to invoke a separate clause that lets parties in an exchange get a 120-day extension if a disaster occurs during the process.

“They have nothing to lose,” she said. “How much worse can it get?”

Hanging over all of these exchanges are incredibly high taxes if they are not completed. An investor who did not find a replacement property would be have to pay a federal capital gains tax of 15 percent to 20 percent, said Mr. Madden of Kay Properties. For example, an investor could lose a $6 million benefit on the capital gains tax of the sale of a building that nets $30 million.

But the investor would also be subject to the Medicare surtax of 3.8 percent, state capital gains taxes of up to 13.3 percent and a depreciation recapture tax of 25 percent for depreciating the value of the building for annual income tax payments, he said.

The benefit — or downside — is often greater with like-kind exchanges than without. The investor can continue flipping the investment tax free until death, when the entire portfolio will be valued at that point. This so-called step-up in basis wipes out decades of embedded capital gains taxes that were never paid. The arrangement benefits the heirs, although the estate taxes could still be owed.

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Paying tax is a regular occurrence for investors in most other public and private markets, from stocks and bonds to hedge fund gains, but it’s a rarity in an industry that benefits from generous tax abatements, deductions, deferrals and reductions.

This time around, however, paying the capital gains tax now may be the better option because falling property values may erase any tax advantage from the exchange.

“Since the market did switch, we’ve seen a few 1031 buyers say, ‘I’m just going to pay the tax,’” Mr. Stein said. “These were buyers who never would have paid tax. I have one friend who said he’s scared that he doesn’t have enough cash.”

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