Outside the box replacement properties when dealing with a 1031 Exchange - by Elliott Hill

Elliott Hill, Prime Property Advisors, LLC

Potential exchangers have two options after selling an investment property. They can either extinguish their tax liability by writing a check to the Treasury, or put those same dollars, Uncle Sam’s dollars, to work for themselves and their estate. The power of a compounding investment is a strong tool; a canceled check…not so much. Internal Revenue Code §1031 allows for the deferral of capital gain and depreciation recapture taxes in the furtherance of acquiring replacement properties. An investor who owns a four-unit rental in Cambridge, can sell his building and exchange into a net-leased property in a more tax-favorable state, like Florida or Texas. If the transactions are properly orchestrated, the investor will be able to avoid recognition of any capital gains, and defer 100% of his tax liability. This tool has allowed individual real estate investors to amass wealth more quickly by maximizing buying power as they reposition their real estate portfolios.

Many investors expect, and may realistically achieve, an annual return of 7% to 8% over some intermediate time frame, say seven to ten years. Not so long ago, these returns could be generated using traditional financial instruments with no real estate required. In today’s market, generating such returns is more difficult, but still achievable.

When evaluating a potential investment property, one of the primary metrics used is referred to as the “cap rate.” The capitalization rate of a given property is computed by dividing the annual net operating income (NOI) by the purchase price. This figure is commonly used to compare the value of different properties on an apples-to-apples basis. As properties become more expensive, cap rates begin to compress. This compression, along with an expected rise in interest rates, has made finding quality real estate increasingly difficult. Recently, an investor was lamenting (her perception) that the commercial real estate market was in such a sorry state. Having sold a rental property in Portsmouth, NH, she was seriously contemplating foregoing an exchange, choosing instead to pay her taxes and park the remaining proceeds in cash, giving a portion to a traditional money manager.

Thinking a little outside the box can provide unique opportunities. Take the energy sector for example. Oil and gas are often components of a balanced portfolio. However, as the past two years have shown, direct investment may not always be best. While the price of oil has proven to be very volatile, the increasingly stringent EPA regulations regarding drilling have remained constant. Specifically, regulations surrounding the treatment and disposal of waste water, a by-product of drilling. Here in the United States, oil wells in the Permian Basin generate approximately 20 million barrels of water by-product per day that must be disposed of or recycled. Disposal wells reclaim any remaining oil and inject the cleaned water approximately two miles below the surface satisfying the guidelines set forth by the EPA. Simply put, without disposal wells, there would be no oil production. This is where the potential opportunity lies. Saltwater disposal wells can be a viable replacement option for investors looking to diversify their exchange proceeds into a uniquely positioned asset.

Prime Property Advisors LLC has over 40 years of combined experience in the real estate industry. Our mantra remains, “A 1031 exchange is an investment strategy first, a tax strategy second.” We offer a full array of replacement solutions including net-leased fee simple properties, medical buildings, multifamily housing complexes, and salt water disposal wells. Through our relationships with developers we are often able to obtain financing and source properties before they hit the market. We have the expertise to guide you through the exchange process to help find a comprehensive solution that meets your replacement property needs.

Elliott Hill is managing partner at Prime Property Advisors, LLC, Saco, ME