Real estate more attractive to investors as stocks struggle

By Carol MacDonald
Contributing Writer

Peggy Whitaker and her husband, P.J., owners of Natural Resources, have sold half a dozen parcels of real estate in the past half dozen years, always with a gain, but never with a tax bill, at least not yet.

That’s because they’ve taken advantage of Section 1031 of the Internal Revenue Service code, which allows capital gains to be deferred on investment property as long as sale proceeds are rolled over into a similar investment.

Like-kind exchanges, as they’re called, aren’t new. They’re used only for investment properties, not primary residences, and they’ve been part of the tax law since the 1920s, when bartering was common. They’re popular with professionals in real estate investing and companies divesting property they no longer need.

But in a booming real estate market, others, like the Whitakers, see advantages, too.

Taxes aren’t forgiven, just deferred, but in the meantime, gains can be used to invest in other properties.

“All you’re doing is deferring the taxes,” says Shawn M. Flanagan, a lawyer with Buist Moore Smythe McGee in Charleston. “If you don’t do the 1031, you have to write a check and pay the tax authorities when you could have the money working for you, investing in more property. If someone is interested in selling and reinvesting, you might as well take advantage, since the IRS allows it.”

“You’ve got to be able to pick the right properties, but it’s easier to make money than a lot of other things,” Whitaker says. “A lot of people in this area are doing it. Buying and selling is really strong here because people are taking advantage of it.”

The number of 1031 exchanges in the area is unclear, but Judith Walk, education director of the Charleston-Trident Association of Realtors, which offers classes on 1031s, says the feedback she gets is that the practice is on the rise.

Charles Sullivan, real estate agent and partner in Carriage Properties Charleston, however, says the percentage of 1031s handled in his office has remained fairly constant, at about 15%, over the past 15 years.

Statistics aren’t available nationally, according to Ralph Bunji, board member and past president of the Federation of Exchange Accommodators, an industry group based in Philadelphia. But interest in real estate investment has grown, as investors look beyond the stock market and baby boomers look toward retirement, he says.

Eric Davidson, a partner in the law firm of Davidson Bennett Wigger, says his firm is doing at least triple the number of 1031 transactions they did five years ago, but they’re also doing a lot more real estate closings in general. Still, he’s certain there’s more interest. “The biggest change is that more people in all walks of life are doing like-kind exchanges for smaller properties,” he says.

Two main reasons are behind the change. “More people are deciding that real estate is a good investment tool over stocks,” Davidson says. And the IRS has treated 1031 exchanges favorably, even in 2002, allowing investors to do what’s called a reverse exchange. In a typical 1031 exchange, an investor sells a property and then finds a replacement for it. In a reverse exchange, the investor identifies a replacement before selling.

Any 1031 exchange is tightly controlled by complex IRS regulations. One misstep in the process can nullify the tax advantages and means an investor will be writing a check to the IRS and the state. “You need a good attorney and a good CPA,” Whitaker says.

“The general rule in tax law is that whenever you’re dealing with an exception to the normal rule—in this case, of paying taxes on gains after buying—then you have to dot all the ‘i’s and cross all the ‘t’s,” Flanagan says.

For a typical 1031 exchange, an investor has just 45 days after selling a property to identify up to three replacement properties, and 180 days to close on one or more properties. The investor must also identify a qualified intermediary, an independent party who holds the proceeds from the sales, Flanagan explained.

“The 45 days runs by very quickly,” Flanagan says, “and if an investor can’t identify properties and get contracts, he’ll get the money back from the QI and have to pay taxes.”

Some 1031 investors buy rental property for current income, he adds. Others are banking on an increase in property values. Knowing the amount that will be deferred can be a factor in deciding whether to do a like-kind exchange, since the cost for hiring qualified professionals is about the same whether the amount deferred is $10,000 or $200,000.

Like-kind exchanges do come with some risk. Investors hope property values will continue to rise. But what if they don’t?

That’s a concern sounded by Bunji, who is a qualified intermediary with clients around the country. On a national level, private and public debt is at an all-time high, he says, and he believes speculation is fueling a bubble nationally. The heightened interest in real estate isn’t necessarily a good thing, says Bunji, who likens it to the “great bubbles of the past” and wonders about a lemming phenomenon or “the great madness of crowds.”

“Historically, deflation occurs every 50 years, squeezing out the excesses, and we’re over due,” he says. “It’s a good time to be cautious and conservative, to have liquidity in your portfolio and not be strung out on debt,” he says.

While area experts say the Charleston market is not entirely insulated from the rest of the country, it has a lot of significant factors working in its favor, most notably supply and demand. The region has seen a massive influx of newcomers over the past decade and that has fueled building growth.

The value of the pulled residential building permits is expected to jump from a projected $1.2 billion in 2005 to $1.3 billion in 2006. That figure reached about $1.1 billion in 2004.

Whitaker sees real opportunities for “little people” like her to leverage gains and buy into property of higher and higher value. “If you’re out and about, there’s property of good value in Charleston,” she says. “Downtown is one of the quaintest cities in the U.S. and waves of people are flocking here.”

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