A Fresh Take on CRE

Why TICs are good! - Part 1 - What is a 1031 Exchange?

As you may know, Grubb & Ellis recently merged with NNN Realty Advisers. As a result of the merger, Grubb & Ellis is now, not only a corporate real estate services firm, but also a leading sponsor of real estate investment programs. Most notably, Grubb is now the number one sponsor in the country of tax-deferred 1031 exchanges via tenant-in-common in partnerships.

What does that mean? Glad you asked!

Let's start off with a primer on 1031 exchanges. 1031 refers to a section of the Internal Revenue code - here's what it says:

"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."

Quite simply, the government will let you defer taxation on the gains from a sale of commercial or investment property if one invests in similar property. Here's an example:

Isabella Investment owns an office building in New York City. She purchased the building in 1990 for $300,000. It's now 2008, and she decides to sell the building. In this market, she can get $2 million for the building. That's a capital gain of $1.7 million. This gain is taxable in the following ways:

  1. Federal capital gains tax of 15%

  2. State and (in the case of New York City), city capital gains taxes. These income taxes depend on your tax bracket, but the rule of thumb, is that these add up to an additional 12%.

  3. Depreciation Recapture tax - a tax on whatever amount of money you depreciated (on a straight line basis) for tax purposes. Recapture tax is 25%.

  4. Excess Depreciation Recapture tax - a tax on certain structures and improvements that you've depreciated on an accelerated basis. This is taxed as normal income, and is up to 35%.

  5. Real property transfer taxes. In NY state, this tax is .4% of the full purchase price. Additionally, New York City applies a 2.625% transfer tax.

In all cases, the first 4 taxes on this list may be deferred. Only in special cases may the transfer tax be deferred as well. Let's see how this plays out for Isabella - we will assume that Isabella fully depreciated her office building:

Scenario 1 - Isabella does not do a 1031:

Sales Price: $2 million
Capital Gains: $1.7 million
Federal Capital Gains Tax: $210,000 ($255,000 - $45,000 covered by recapture tax)
State & City Capital Gains Taxes: $204,000
Depreciation Recapture Tax: $75,000
Excess Depreciation Recapture Tax: For the purpose of this example, we'll assume this doesn't apply although it would likely only make her taxes higher!
Transfer Taxes: $60,500
Total Taxes: $549,500
Total Tax %: 27.5%
Equity to Reinvest: $1,450,500

Scenario 2 - Isabella does a 1031 exchange:

Sales Price: $2 million
Capital Gains: $1.7 million
Transfer Taxes: $60,500
Total Taxes: $60,500
Total Tax %: 3%
Equity to Reinvest: $1,939,500