(Re-posting this from my BP blog in case it's helpful to any of the forum readers. This is far from an exhaustive analysis into the mechanics of 1031 exchanges, but the high level thinking may be helpful to those looking to understand one of many dynamics impacting the current buying landscape. As always, open to all feedback)
READ TIME: 2 min
Having a hard time getting your bids accepted? Wondering how buyers are rationalizing offers way above asking? The tax code may be the answer.
One main reason, particularly for those of you bidding on mid to larger commercial properties, is 1031 exchanges. In short, a 1031 exchange refers to a portion of the tax code that allows a seller to re-deploy their sale proceeds, tax free, in a like-kind exchange.
By way of the most simplest of examples, let's assume I'm selling a property and expect gross proceeds of $1mm, with a total tax liability of $350k. That means I'd have $650k left to invest in another property, and at 25% down, that equates to $2.6mm of purchasing power ($650k / 0.25). BUT, if I did a 1031 exchange, I could re-invest my entire gross proceeds ($1mm) into another property, and at 25% down, I'd have $4mm of purchasing power ($1mm / 0.25). With greater scale comes potential for greater returns (more leverage, cash flow, appreciation, etc), so the latter option here is quite appealing...right?
Yes, except for those of us bidding against 1031 investors. Allow me to explain.
While you may be bidding on the direct merits of a property (e.g. how much it cash flows after PITI and OPEX), where a bid above listing price makes zero economic sense, a 1031 investor is evaluating the investment from the POV of their OVERALL exchange. What may be a breakeven or even negative direct ROI at that inflated purchase price for you is actually a major economic win for the other investor when the 1031 tax savings from their recent sale are factored in.
This is happening A LOT in the midwest, where investors with recent asset sales in CA and CO are seeking to re-deploy their exit proceeds in new acquisition targets. And, since there's a ticking clock on identifying a new property to purchase, a 1031 investor could get very aggressive on price (and overall deal terms) to get a deal done quickly.
How's that for a competitive bid process? Eek is right!
After your initial grumblings, realize that this is yet ANOTHER reason (of many) to invest in real estate...the tax advantages are numerous and give RE investors a big advantage compared to those focused on other asset classes (pending any legislation changes). Further, it's also a reason why you should start buying RE sooner rather than later --> the 1031 exchange is at your disposal when you have something to sell...and buy.
(NOTE: If you want to nerd out on the details of 1031 exchanges, and there are many, here is one article that summarizes it well and has links to additional FAQs).
@Christopher Erwin , You're expressing a common sentiment but I think it deserves to be tempered with some commentary perspective. 1031s represent less than 10% of the entire sales numbers. So that small of a % is going to be pressed to have that much negative impact on offers.
I'd say there are some other equally dynamic factors at work as well.
1. Cash sales
2. Unrealistic buyer expectations (and memories) from the past.
3. Seller demands in a rising market.
4. Cheap money
There's something interesting on the flip side of this argument also that has me intrigued. As the market becomes more and more uncertain and returns get squeezed tighter, the flexibility of the 1031 investor to purchase at a higher price point and still maintain their returns seems to me to be another advantage of the 1031 exchange in an unstable market.
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