Generally, if you exchange investment property solely for investment property of a like kind, gain may be deferred into the future under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received.

Section 1031 does not apply to exchanges of inventory,stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets and only applies to passive investment real property.

In evaluating whether a Section 1031 exchange is right for you, the first step is to contact your tax professional (CPA or tax attorney) and determine the taxable basis of the property you wish to sell. This will allow you to determine the amount of tax that you can defer.

Section 1031 real-estate exchanges are back — and that means investors need to be cautious.


In the cycle of investment life boom, bust and aftermath the lessons only become clear after it’s too late.

So it goes with a once-hot real-estate investment that has left wreckage in its wake and a fresh reminder: When there’s a simple way and a complicated way to solve a problem, the middleman will almost always make more money off the complicated solution but you might not.

Between 2004 and 2008, investors bought $13 billion worth of securities often called tenancies-in-common, or “TICs,” according to OMNI Real Estate Services of Salt Lake City. Also known as 1031 exchanges after a part of the tax code, TICs are complex deals that enable the sellers of real estate to roll their proceeds over into other properties without incurring capital-gains tax. TICs were tailor-made for a real-estate bubble.

The deals were structured as privately placed securities that don’t trade; up to 35 investors can own stakes in a TIC, while a newer format can be held by up to 499 investors. The buyers get a stake in the rental income and potential sale of one or more commercial, retail or residential properties.

Properly structured, 1031-exchange securities can enable investors to shelter real-estate sales from capital-gains taxes, to obtain regular income and to bequeath the asset to their heirs in a tax-efficient manner.

But Wall Street took an idea that is suitable only for a limited number of specialized, wealthy clients and sold it to ordinary investors in some cases with disastrous results.

Consider what happened to Mary Boston, 70, of Dunlap, Tenn. In 2007 she and her husband, Lavaughn, sold their local theater for $1.2 million, net of debt. Their tax preparer suggested that a financial adviser might be able to help them arrange a 1031 exchange.

The couple sank the $1.2 million essentially their entire liquid net worth into two TICs that gave them a stake in two apartment complexes, one in Georgia and one in Texas. The offering documents projected an annual yield of 6.5%.

The couple had no previous investment experience, and Mrs. Boston says she told the adviser that they had a “conservative and moderate” appetite for risk, with “income” as their investment objective.

Section 1031 exchanges must be executed on a precise, tight schedule. Mrs. Boston says she repeatedly raced back and forth to Chattanooga, Tenn., to send required documents by overnight delivery. But she says her adviser warned that it would “cost a lot of money” to undo the transaction.

After the deals closed, the Bostons, along with other investors, had to pony up more money when one of the properties became entangled in lawsuits. Between the capital they added and legal fees, says Mrs. Boston, the couple has sunk roughly $70,000 more into the property.

Meanwhile, the monthly income on their investment has fallen from about $5,000 to $300 and is projected by the property manager to dry up entirely next month. Vacancy rates have spiked, partly because of negative publicity after a double homicide this summer at one of the apartment complexes.

The Bostons are seeking redress through arbitration with the financial adviser. With the case pending, the adviser’s current firm, ING Financial Partners, declined to comment or to make her available.

Small TICs like the Bostons’ weren’t the only ones that had problems. Two big TIC sponsors, DBSI and Sunwest Management, raised nearly $1 billion, then sought bankruptcy protection in 2008 and 2009 after their deals went bad.

Amid the bad publicity and a drought of bank lending, the industry’s transaction volume fell by 95% from the peak in 2006 to the trough in 2010.

But the few conservative sponsors left are making a minor comeback. Patricia DelRosso, president of Inland Private Capital, estimates that her firm will raise about $160 million in 1031-exchange deals this year, double its levels last year. Bill Winn, president of Passco, another sponsor, reckons that offerings will be up around 20% over 2010.

If you’re considering a 1031 deal, proceed cautiously: It probably makes sense only if you are already planning to sell a property and to reinvest the proceeds into other real estate assets, say tax experts.

Otherwise, it’s hardly worth paying a 7% or greater commission just to avoid a 15% capital-gains tax. Plus, there is no secondary market for these assets, so “you’re toast if you need to sell” before the properties are ultimately resold, says Brandon Balkman, executive director of the Real Estate Investment Securities Association, a trade group.

The next time someone comes calling with a complex, high-fee product, remind yourself before it’s too late that there probably is a simpler, cheaper alternative.

Read the original story here.