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McNellis: Is the 1031 Exchange Panacea or Placebo?

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1031 exchange, California, Canadians, American, property, real estate, S&P 500, Walgreen, South Dakota, taxes, investment

By John McNellis

McNellis
Upon selling a supermarket last week, we deposited our proceeds into a 1031 exchange account. Call this maneuver the triumph of hope over experience, because we have had precious little luck exchanging properties over the past ten years, pulling off just one trade from among a half dozen attempted. What happened with the failures? Simple, in each instance we decided we would rather pay the taxes than trade into properties that were—in our view—wickedly over-priced or snake-bitten with risk.

Why are we trying again? Because now may be retail’s time. Buyers are migrating away from retail, sellers are soul-searching and, somewhere between still gaudily-priced trophy properties and power centers beset with “box risk”, we might find a decent deal: that is, an unleveraged eight percent return without untoward risk. Whether this will prove out remains to be seen, a topic for another day.

Let’s instead consider the 1031 exchange itself. It is unquestionably the greatest gift to the brokerage industry since Moses decreed the six percent commission (try paying less on a house sale and you’ll learn how deeply this commandment was carved in stone). Absent the 1031, a large but unknowable percentage of owners will never sell, preferring to ride a property straight off a cliff rather than pay avoidable taxes. (About one-third of all 2017 California deals involved a 1031 exchange buyer). Thanks to its palliative effect, America’s commercial deal volume is significantly greater than in countries that tax real estate sales profits. As decent and good-hearted as Canadians surely are, they share our Yankee enthusiasm for tax avoidance and, as a result, Canadian deal flow per capita is about 85 percent of ours. Yes, American brokers should all have tattoos that read “Born to 1031,” but is it that great a deal for principals?

It depends.

It depends on how you invest in real estate. Successfully exchanging is harder if you’re a developer rather than what is widely, if inaccurately, known as a “passive investor.” Developers want wholesale, risk-laden real estate to which they can add real value. You can find wholesale deals in the 45-day designation period, high-risk career projects, but relatively seldom can you solve or swallow half of their risks within the 180 day closing limitation. By the way, a great way to go “one and out” is to close on a deal with untamed risks.

On the other hand, if you’re that passive investor, if your milieu is finished, 100 percent leased real estate, you can readily find that within the 45 day identification period, wring out or assume whatever risk the property entails and have time enough to close within the overall 180 day period. Whether the deal will have a happy ending is another story—ask long-time veterans about their worst deals and, often as not, they began with a trade.

As importantly, the efficacy of the 1031 as a wealth-builder (presumably your ultimate goal) depends on the breadth of your financial perspective, your perceived range of investment alternatives. If you’re starting out, if your portfolio consists of real estate and pocket change for pizza (basically, my financial statement for many years), if every dime you have is either invested in property or sitting in a bank earning zero percent, the 1031 is as critical to your success as a booster rocket is to the Space Shuttle: it’s the only way to get lift-off. Even trading into a marginally-located Walgreen’s with a fixed return of 5 percent is lights-out better than paying 33 percent in taxes (if you’re in California) and having your remainder earn zero.

If, on the other hand, you have a little more experience and could be comfortable with investing in nothing more exotic than an indexed mutual fund (one consisting of a broad basket of a stock exchange’s representative companies) you might be doing yourself a disservice buying that Walgreen’s.

Even in tax-crushed California, the math is intriguing. Buy the Walgreen’s and you’re neck-deep in concrete: you have a 5 percent yield for the rest of your life and the hope that the property has residual value when the lease burns off (i.e. that prescription drugs are not delivered by drone). Pay your combined state and federal taxes of about 33 percent, you have total liquidity and you need only average 7.5 percent on your after-tax dollars to equal your Walgreen’s 5 percent.

This is not an idle comparison. Taken as a whole, the S&P 500 has averaged somewhere between a 7.5 and 10 percent total return since 1928 (pundits vary in their estimates; the Federal Reserve’s own raw data suggests a shade under 9 percent). If this long-term trend were to continue (Warren Buffet is quite certain it will), you would be far better off paying your taxes, putting away the balance into the market and letting it grow rather than worry about leaky roofs and Walgreen’s bending you over the next time its lease extension option arises.

And I will tell you from personal experience that your jaundiced banker is far more impressed with $10,000 in a Fidelity account—real money—than with your claimed equity of $100,000 in an LLC.

If you can stumble across a fair deal in the 45 days, the 1031 is your best friend. But before you pull the trigger on a Walgreen’s in South Dakota, you might consider paying your taxes and expanding your investment horizons.

John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.

Articles published in our Contributor section do not necessarily represent the views of The Registry or Mighty Dot Media, Inc. They represent a selection of topics chosen for the value of their editorial perspective. We welcome feedback and alternative positions on topics, and we will consider publishing those, as well.

mcnellis-book-coverTo read more from McNellis, please consider his book Making It in Real Estate: Starting Out as a Developer.