My heart goes out to all of those real estate investors who sold a property before COVID-19 struck. Most folks had it all planned out. They were going to avoid paying capital gains taxes on the sale of their property with a 1031 exchange.
Now, investors are having difficulty completing their 1031 exchanges. A government extension (until July 15th) gives them more time to close on a new property, but it isn’t enough.
Investing in Opportunity Zone Funds is an excellent alternative to a 1031 exchange with similar tax benefits and a lot less stress.
I’ve worked in the real estate world for nearly two decades, and I’ve seen my share of complex property transactions when it comes to 1031 exchanges. While an exchange can be a terrific tax-free investment strategy, it can also be a tricky deal that goes south fast.
To qualify for the 1031 exchange tax benefits, real estate investors must identify their next property purchase within 45 days of selling their last property. And they must reinvest their gains in a replacement property of equal or greater value within 180 days.
In this uncertain market, I’m talking to tons of investors who are struggling to find 1031 exchanges before the impending July 15th IRS deadline.
In the San Francisco Bay Area alone, the number of 1031 exchanges fell by 40 percent starting in March, according to Ron Ricard with the national intermediary firm IPX 1031, who recently led a webinar on 1031s with me.
Starting in March, we saw a significant increase in the number of these investors coming to our fund with capital gains from the sale of real estate.
We aren’t alone. Opportunity Zone Fund fundraising accelerated across the country this spring, according to media accounts and reports from other OZ Fund managers.
Here’s what investors and experts are saying about the most common 1031 exchange pitfalls to watch out for in today’s challenging market:
1. Finances might fall through at the last minute
You had your bank all lined up to give you a loan close escrow on your 1031 exchange property. Then the bank saw the April rent roll from the building, and 50 percent of the tenants didn’t pay rent because of COVID-19. Now the bank either won’t give you the loan or (for example) they will give you 40 percent loan to value instead of 70 percent loan to value. Many folks don’t have the financial ability to come up with the additional funds necessary to close escrow.
2. You’re buying blind
Shelter-in-place guidelines made it extremely difficult for buyers to tour and inspect properties. Many buyers don’t feel comfortable closing escrow on a property they have not seen.
3. You can’t find a replacement property, especially one that will make you money
While it’s always challenging to find real estate investments that provide returns equal to or higher than that of the building you are selling, it’s particularly challenging during a pandemic.
Inventory is low. Even before the pandemic, the supply of homes for sale was falling across the nation. December saw the largest year-over-year decline of housing inventory in almost three years, with a 12 percent dip, according to Realtor.com. And now fewer properties are hitting the market—because why would someone sell during a pandemic unless they absolutely have to?
Also, believe it or not, home prices are still rising in tight markets such as in the Bay Area.
Beware if you are looking to invest in rental properties. Longtime Bay Area realtor and consultant Elisabeth Watson recently told me she looked at nearly 60 multifamily and commercial properties for her 1031 exchange client and found nothing that would generate positive, or even neutral, cash flow because of high sale prices, relatively low rents, and rent control.
OZ funds offer a solution to failed 1031 exchanges
In light of today’s COVID-19 challenges, people tell me they want an easier to understand, easier to execute real estate reinvestment strategy, with tax benefits that are similar to a 1031 exchange. So, they’re looking at Opportunity Zone Funds because, like 1031 exchanges, OZ Funds are real estate investments, have the same investment timeline (180 days), and have capital gains tax deferral benefits.
OZs were created as part of the 2017 Tax Cuts and Jobs Act, which allows investors to roll over capital gains from the sale of a property, business, or stocks into a fund that’s investing in development in distressed communities. Investors get to defer, reduce, and even eliminate their capital gains tax burden.
OZ Funds are uniquely positioned to ride out these uncertain times because OZ Funds have a long investment horizon. At Urban Catalyst, for example, we’re developing seven housing and commercial projects in downtown San Jose and plan to distribute profits from our assets over the next 10 years.
OZ Funds are also in a unique position because many developments around the nation haven’t broken ground yet, which means the pandemic and shelter-in-place orders haven’t caused much construction delays. That is certainly the case with Urban Catalyst.
When we do break ground, construction costs might be lower than pre-pandemic levels. I saw construction prices in the Bay Area decline by 20 percent during the 2008 recession. If history repeats itself, we’re looking at significant savings.
In addition to OZ Funds being recession-resistant, I find that former 1031 investors are attracted to our mission to revitalize our local communities, more so than ever since the pandemic.
OZ Funds provide a once-in-a-lifetime answer to 1031 exchange woes while fulfilling a larger purpose. It doesn’t get better than that.
Eric Hayden is the founder of San Jose, Calif.-based Urban Catalyst. He has been responsible for developing more than $3.5 billion in real estate projects.