By Brandon M. Hughes
The 1031 exchange market nationally has been like a roller coaster this past spring and summer, plummeting down in April and roaring back up starting in June. Surprisingly, the residential side of Arizona real estate has not experienced the same tumultuous highs and lows seen in the commercial and exchange markets. Phoenix metro still sits at the top of the country for year-over-year home price growth, necessitating the need for the tax deferral benefits of 1031 exchanges. Rent price growth is no different with equal pushes to the country’s price growth lists. It’s a seller’s market in Arizona.
In late March and April exchange activity in Arizona dropped off significantly as a result of the COVID-19 pandemic which forced the entire nation to work from home and/or shelter at home. The Treasury provided tax relief to some investors with Notice 2020-23 which extended many deadlines for investors affected by the COVID-19 pandemic including Section 1031 exchange time deadlines. Notice 2020-23 extended the 45-day identification period deadline and 180-day exchange period for certain investors until July 15, 2020. (Note: There is no further extension in place currently.)
After a large drop in exchange transactions, where activity was about half of normal in late March and April, in May exchange transactional volume trended upward slightly as states slowly anticipated loosening restrictions and businesses reopened again. Additionally, real estate professionals and investors were beginning to adjust to virtual transactions. Video and interactive tours of properties replaced in-person inspections and walkthroughs. Closing offices and the title insurance industry innovated quickly in response to these new challenges. The marketplace adjusted to closing transactions virtually as new technologies and processes like virtual notaries rapidly evolved to help sellers and buyers’ close transactions.
On June 11, 2020, the Treasury released proposed regulations addressing what is considered “real property” for Section 1031 exchange purposes after the enactment of Tax Cuts and Jobs Act (TCJA.) The proposed Treasury Regulations defined real property as land, “inherently permanent structures,” “structural components” of inherently permanent structures, unsevered crops, water and space adjacent to land, interest in real property such as fee ownership, co-ownership, leasehold, easement, option to acquire real property as well as a license, permit, similar rights solely for the use, enjoyment or occupation of land and/or inherently permanent structure. The Proposed Treasury Regulations also clarified that local law definitions are not controlling in determining whether property is real property and noted that every distinct asset must be analyzed separately to determine if the asset qualifies as real property.
Also, in June 1031 exchange activity picked up considerably across parts of Maricopa and Pima counties. This trend has continued into July and shows no signs of slowing down in Arizona.
RESIDENTIAL 1031 EXCHANGE MARKET
The mix of 1031 exchange activity in Arizona has changed from early spring until now. There are considerably more residential exchanges and transactions involving single-family homes, 1-4 unit townhomes and condos, land, vacation homes held for investment, farms/ranches, compared to commercial exchange transactions. There are several reasons for the uptick in residential exchange activity:
- The normal strong spring selling season in Arizona was compressed and has been pushed back a couple of months into summer and likely fall. Past years have shown us the months of September and October to be the worst for Arizona real estate. That could change.
- Historically low-interest rates have made financing residential transactions especially attractive for investors and homeowners. The interest rate for a 30-year mortgage dropped below 3% making the cost of financing very attractive and boosting cash flow for investors.
- Investors continue to move their investment properties out of California and into the attractive Arizona market. Not only do these investors stand to receive lower property taxes, but they see the value in lower income and sales tax rates as well.
- In late March and April, many sellers decided not to list their properties as no one wanted strangers touring homes when there was so much uncertainty regarding COVID-19. The lack of new listings led to less inventory and more demand for existing properties on the market. In fact, residential demand is so robust that many areas nationally are currently seeing bidding wars for residential properties. These bidding wars affect both home buyers and those seeking to purchase single-family rental (SFR) properties in 1031 exchanges. It is not uncommon for a property to go under contract the same day it hits the real estate market. This has created a challenging situation for exchange investors who must move quickly to identify replacement property within the 45-day identification period.
- Some investors are exchanging out of real estate located in downtown areas that are seeing increased protest activity and fleeing for the safety of suburbs which have become more desirable these past few months.
- Other investors are planning to purchase property in more remote areas. Many rural and mountain towns are seeing a big increase in demand.
THE COMMERCIAL 1031 EXCHANGE MARKET
The volume of commercial transactions nationwide has dropped due to many variables. In some cases, buyers have dropped out of contract due to uncertainty about the future. In late March and April, commercial financing become difficult to obtain. Non-QM financing froze up completely and many exchange investors had lenders saying they could no longer fund loans for the acquisition of replacement property and buyers under contract to purchase exchange properties faced these same financing challenges. Also, some investors, concerned about a looming recession, chose to sell and pay taxes as they raised cash to survive the downturn.
There are segments of the commercial market such as the $240 billion hotel industry that are facing massive unemployment and unforeseen vacancy rates. The leisure and hospitality industry has lost 4.8 million jobs. Business travel has slowed to a trickle and been transformed with virtual meetings using applications like Zoom, Skype, Facetime or Microsoft Teams. Other segments of the commercial market are seeing major disruptions. As employers have adjusted to employees working from home, the demand for office space has dropped and will likely never return to where it was before the pandemic. Office vacancy rates could reach 25% or more. In addition, projections indicate 20-25% of the strip malls and shopping centers are at risk of going bankrupt unless they see a new mix of tenants fill vacancies. About 25% of the restaurants will not be able to survive under current market conditions. One positive segment in the commercial market is the industrial sector. Internet sales and online activity has pushed consumer activity towards more online commerce needing more distribution center capacity and away from traditional brick and mortar local businesses. The bottom line is many commercial properties nationwide will need to be repurposed as the business community adapts to the new economy. The disruption in the commercial market nationally will take years to fully adjust and recover.
WHAT LIES AHEAD
Democratic Presidential candidate Joe Biden has proposed eliminating many “tax loopholes” and raising about $4 trillion in new taxes. He wants to increase individual taxes, corporate taxes, and capital gain taxes. Recently, he unveiled a proposed $775 billion plan to provide more funding for children and the elderly financed by taxes on real estate investors with incomes more than $400,000, increased tax compliance, and targeting 1031 tax-deferred exchanges. This would mark the first major change in the 1031 industry since the Republican Tax Cuts and Jobs Act of 2017 limited tax-deferred exchanges to like-kind real property.
Brandon Hughes is a Division Manager with Asset Preservation, Inc., a leading national IRC §1031 Qualified Intermediary. He can be reached at email@example.com or (833) 756-1031.