AUSTIN, TX—Up until this year, April 15 was an important date, representing the deadline for US residents and citizens to file federal income taxes. However, in the current COVID-19 environment, that drop-dead deadline has been pushed to July 15.
The upcoming mid-July deadline is also important for those making use of §1031 of the US Internal Revenue Code, which allows capital gains tax deferrals on investment property sales. The IRC section, “Exchange of real property held for productive use or investment” allows investors to “exchange” original assets into “real property of like kind”.
In normal times, investors involved with this exchange would have 45 days from which the original property was sold to find a like-kind replacement property. If that replacement property wasn’t found, investors would be required to pay taxes on the capital gains from the initial sale.
“We are, however, living in the COVID-19 environment. In light of that, the IRS extended that 45-day deadline for in-flight investors in the middle of the exchange process, whose original property sales dates fell between April 1, 2020 and July 14, 2020. These investors have until July 15 to find that replacement property,” David Wieland, Realized Holdings CEO, tells GlobeSt.com. “So, in the pre-coronavirus world, an investor who sold his or her net-lease asset during the first week of April as part of a 1031 exchange would have had to find a replacement apartment complex or duplex by mid-May. In the COVID-19 environment, however, that investor has had more than two months to find that replacement asset. While this extension might seem advantageous for 1031 exchangers, the situation is actually a double-edged sword.”
One issue faced by in-flight and other 1031 exchange investors involves demand and supply. On the demand side, Realized Holdings determined there is approximately $10 billion worth of 1031 exchange equity seeking replacement properties. This equity is originating from a couple of sources.
The first involves investors who might have closed on original properties in late May, officially starting the 45-day timer to find a replacement asset. The second source consists of investors whose original properties sold in April, but whose replacement-property deadlines are now in mid-July.
“These entities haven’t yet found their replacement properties,” Drew Reynolds, Realized Holdings CIO, tells GlobeSt.com. “What this means is more investors competing for the same supply. And speaking of supply, the amount of available real estate assets for sale or exchange hasn’t changed much. In fact, due to the COVID-19 environment, availability has actually decreased.”
In one situation, the available supply of rental homes and duplexes has decreased by 20%. Similar scarcity is evident among net lease and other commercial real estate properties.
“Sellers, understandably, are anxious to dispose of their real estate due to the current recession,” Reynolds observes. “They are holding on to their properties, waiting on the sidelines for the economy to improve. In other cases, sellers are actively pulling their properties from the market.”
In addition, investors fortunate enough to find replacement properties are finding huge spreads between their offers and what sellers are willing to accept. Sellers are asking for pre-coronavirus pricing, while buyers are eyeing current economic uncertainties when making their offers, leading to lower bids. This disconnect is leading to collapsing deals and stalled sales, says Wieland.
Realized Holdings indicates that approximately 80% of 1031 exchange transactions require a mortgage to meet the necessary requirements for a successful deal. The good news is that banks are sitting on strong capital reserves. The bad news is that actually accessing that capital is becoming more challenging.
“Today’s banks and lending institutions are up to their figurative elbows, as they are handling a glut of loan forbearance tasks and refinancing applications,” Wieland tells GlobeSt.com. “These institutions are also working with COVID-19-related programs, such as the Payback Protection Program and other cash and credit assistance methods for individuals and small businesses.”
This means less time is available for lending staff to underwrite and issue original mortgages, leading to longer time frames for approvals. If those time frames bypass the 1031-exchange July 15 deadline, the borrowers could be on the hook for additional taxes.
“Additionally, stringent lending requirements mean investors need stellar credit scores with a FICO score of at least 700 to qualify for mortgages,” Wieland tells GlobeSt.com. “Lower loan-to-value agreements have also been an issue, meaning higher equity requirements. Adding to the financial uncertainty is that lenders can re-trade or pull a loan up until closing.”
Having introduced some of the problems exchange investors are currently facing, here are a couple of solutions:
First, if it hasn’t happened already, now is the time to start an in-depth search for that replacement property. Investors should also be realistic when it comes to making offers. It’s a seller’s market, and while a bid does need to pencil out to make sense, now is not necessarily the time for aggressive negotiations in attempts to lower the asking price.
Second, it’s important that investors open a dialogue with their lenders to determine their financing eligibility as well as to understand the approximate timeframe for loan application and approval.
“While the 1031 exchange extension has provided some breathing room, it’s important that investors not waste any more time in finding that replacement property or nailing down a loan to finance it,” Wieland tells GlobeSt.com. “The final 45-day clock is ticking. Failure to heed that timer could mean a hefty tax bill when the July 15 deadline rolls around.”
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