By Michele Lerner

Commonplace in the real estate investment world, a 1031 exchange, also known as a tax-deferred or like-kind exchange, provides an effective method for property to be bought and sold while being able to defer federal income taxes on the transaction. Tax-deferred exchanges benefit a REIT strategy by preserving capital and helping to maintain a steady flow of dividends. They are also vital tools for individual investors looking to maximize direct real estate investments.

"Most REITs use 1031 exchanges on a regular basis, regardless of what type of sector they are in, except mortgage REITs," says Lou Weller, national director of Real Estate Transaction Planning and principal with Deloitte Tax LLP. "REITs sometimes choose not to do a tax-deferred exchange for a casual sale, and sometimes they want to sell property to generate cash, but more often they choose to do an exchange."

According to Adam Handler, leader of Pricewaterhouse-Cooper's Like-Kind Exchange consulting practice, "Essentially, a 1031 exchange means that you are exchanging one property for another 'like-kind' property so that you can defer the taxes on the property you are relinquishing. It's important to understand this is a deferral, not an elimination of the taxes."

In 1991, the IRS issued "safe-harbor" regulations which established procedures for handling an exchange through the use of an intermediary, direct deeding and the use of qualified escrow accounts, according to the 1031 Corporation, which specializes in tax-deferred exchanges.

"There are a number of restrictions on these exchanges. First, the property must be held for productive use in a trade or business or for investment. Since inventory does not qualify, you cannot use a 1031 exchange for home building or for condominium conversions," Handler says. "The courts have said that, generally, all real property is 'like-kind' property, so you could, in theory at least, exchange a farm in Kansas for an office building in New York City as 'like-kind' properties. Consequently, raw land can be exchanged for income-producing real estate. To defer all of the capital gain, the replacement property must be equal to or greater in gross fair market value and net equity to the property being relinquished. The properties have to be exchanged, not bought and sold." Many investors often mistakenly believe they can exchange appreciated real estate for REIT stock. However, REIT stock is not considered "like kind" property for real estate.

Being aware of and following the rules established by the IRS for tax-deferred exchanges is crucial for investors.

"I think 1031s are both easy and difficult," Handler says. "The broad rules are well understood and professional companies can help set them up, but there's lots of technical work that goes along with them. If you are unfamiliar with them and you get help, you'll be fine. If you are sophisticated and knowledgeable enough to handle it, you can do it yourself. Some people think they know what they are doing, but sometimes it's more complicated than people realize and they can get themselves in trouble."

Tax-deferred exchanges are usually handled by a "qualified intermediary" or "QI", says Handler, who describes the QI as "essentially a legal tax straw man who stands in the middle of the exchange." In addition to the QI, the essential requirements of a 1031 exchange are that once a property is placed in an exchange, the owner has 45 days to identify the property which will be exchanged and 180 days to acquire the exchange.

The time frame begins with the date of relinquishing a property into an exchange. "1031 Exchanges are a very form-driven type of transaction," Weller says. "The time limits are very important, so investors who want to do a like-kind exchange need to be very familiar with all the technical requirements. You cannot come to it after the fact and try to do an exchange. You must have an independent third party to hold the funds while you do the exchange, but those companies don't give you tax advice. For tax advice related to an exchange you need to consult a tax expert."

Several other types of exchanges have been approved by the IRS, including a simultaneous exchange in which the property exchange takes place on the same day, and a delayed exchange which takes place within 180 days.

"IRS guidelines also allow what's officially called a 'Qualified Exchange Accommodation Agreement,' generally known as a 'reverse exchange,' in which a company can buy and park a replacement property for 180 days while waiting to sell something," Handler says. "Reverse exchanges are very popular with REITs, because they are a little less scary. The property they have bought can even be fixed up so that its value increases during that 180-day exchange period."

Advantages for REITs

The biggest advantage for REITs in a 1031 exchange is that the taxes from a sale are deferred, allowing the REIT to take advantage of the time value of money, Handler says.

"All decisions about like-kind exchanges are a function of dividends," Weller adds. "If the REIT needs to sell a property to reach a certain dividend level they will do that instead of an exchange. If they are selling tiny assets they may not bother with an exchange, but if they are selling large assets they are more likely to want to do an exchange."

According to Handler, "REITs do a lot of 1031 Exchanges because even though they don't pay taxes to the extent they distribute dividends to shareholders, they generally distribute 90 to 100 percent of their taxable income, so they are always looking for capital sources. If they sell their property for taxable gain they generally distribute that gain to their shareholders. It makes more sense often to defer the taxable income by doing an exchange."

Like-kind exchanges also benefit REITs by maintaining the size of a REIT's portfolio while simultaneously allowing it to alter its holdings.

"REITs can use like-kind exchanges to avoid shrinking the REIT," Weller says. "Any property distribution that triggers a capital gains tax requires the REIT to allocate the taxes as a distribution to the shareholders, which in effect, shrinks the REIT. Of course, if a REIT is deliberately shrinking they wouldn't want to do a 1031 exchange, and they wouldn't want to do this when they are in financial difficulties, either."

Maintaining a steady dividend flow is equally important to a REIT. "REITs like to have steady dividends and when a property sells and they need to distribute the taxable income to their shareholders, it can create lumps in their dividends," Handler says. "A like-kind exchange can help even out the dividends year-round."

Weller agrees. "REITs want relatively stable dividend flows, and they don't want a bubble in the dividend which is created when you have a large sale. They don't want to be inconsistent over the course of a year."

Reasons for Caution

In spite of the many advantages to tax-deferred exchanges, they can sometimes be a mistake for a property owner.

"The biggest disadvantage to a like-kind exchange is if you can't find an adequate replacement property," Handler says. "Sometimes a 1031 exchange can't be done because of the timing restrictions. Also, if there's nothing that makes a decent acquisition, then it doesn't make sense to do one. The deferral of taxes won't ever make up for a bad investment."

According to Weller, "The major disadvantage to a 1031 exchange is the pressure to buy another property under the time limitations of the system. Some people think that because a REIT is a big professional company they can handle this more easily than an individual investor, but they still face significant pressure. A less important disadvantage to a 1031 is the transaction cost, which is not terribly expensive but wouldn't be incurred in a normal buying and selling situation."

A failed tax-deferred exchange does not incur additional penalties to a REIT, or other property owner, beyond the necessity of paying the tax.

"If for some reason a REIT cannot find a property to purchase before the end of the 180 days, then the REIT simply takes the money from the sale, distributes the proceeds as a capital gain dividend, and then the shareholders pay the capital gains tax," Weller says. "There is no penalty for the failure of the exchange. The only loss would be that the REIT has to make the tax distribution to shareholders and that they did not have the sales revenue for the 180 days."

Several Kinds of Like-Kind Exchanges:
Type	Characteristics
Simultaneous	Properties exchanged at same time Often only two parties Oldest form, but uncommon
Deferred (aka "Delayed," "Starker," "Non-Simultaneous")	Relinquished property sells before replacement property purchased Generally uses qualified intermediary to receive and hold sales proceeds Usually three parties: exchanger, buyer & seller Must "identify" replacement property within 45 days and acquire within 180 days from relinquished property sale Most common
Safe Harbor Reverse (per Rev. Proc. 2000-37)	Replacement property must be purchased before relinquished property sold Exchanger can't own both replacement and relinquished properties at same time, so typically uses Exchange Accommodation Titleholder (EAT) to purchase replacement property Funds to buy replacement property supplied by exchanger "Safe Harbor" permits maximum 180 day ownership by EAT Completed using QI to receive proceeds and buy property from EAT. Alternate structure possible if exchanger needs direct ownership of replacement property immediately
Non-Safe Harbor Reverse	When accommodator must own property for more than 180 days. So safe harbor not available Potentially requires accommodator to invest funds in order to have "benefits & burdens" of owning property
Construction or Build to Suit	When replacement property will be built or improved Uses safe harbor or non-safe harbor accommodation structure above