Recent Tax Developments in Commercial Real Estate

Article excerpt

Opportunities for deferring capital gains and lowering estate and gift taxes

Historically, commercial real estate has been a good hedge against unforeseen inflation bursts similar to that experienced in the late 1970s. Some of the well known risks of investing in commercial real estate involve fluctuations in real estate values, potential difficulties of reselling property for its appraised value, changes in occupancy rates and operating expenses, unforeseen repairs and renovations, and the possibility of environmental problems and liability.

In the 1980s institutional investors, such as pension funds, insurance companies, and savings and loan associations began to invest heavily in real estate. The tax laws prompted private individuals searching for paper losses to also invest in real estate. These investments drove up prices and encouraged widespread overbuilding. When the tax benefits were repealed in 1986, prices dropped and many lost money. In addition, an economic recession in the 1980s occurred, precipitating a dramatically reduced demand for all new space. The resulting oversupply has remained a problem for almost a decade. However, in the opinion of some analysts, the excess is being absorbed and certain markets are beginning construction again. Investments in commercial real estate, including industrial facilities, suburban office buildings, neighborhood shopping centers, and multifamily residential projects have not correlated very closely with stock market movements, making them a good diversification tool. A well-diversified portfolio of commercial real estate, selectively purchased and prudently managed, has the potential to provide long-term capital appreciation as well as a consistent stream of income.

No one can accurately predict whether the second half of the 1990s will experience a rise in commercial real estate values, but many real estate owners and developers have decided there are good arguments for investing in commercial real estate. Corporations have been increasingly attracted to real estate as an investment offering both potential appreciation and tax shelter. Corporations have a significant advantage over individuals because corporations are exempt from the passive loss rules.

Like Kind Exchanges

A significant tax break is found in IRC section 1031. It allows taxpayers to swap one property for substantially similar property without capital gains tax. The transactions are referred to as 1031 swaps or like kind exchanges. By exchanging one property for another of at least equal value, owners and developers can defer capital gains taxes that otherwise would have been due if they had sold the first property and bought the second. The main condition is that the exchange property must be "property held for investment or used in the course of a trade or business," not personal property or a family residence. Properties not covered include stock in a trade or business or other property held primarily for sale.

Any kind of commercial real estate can be swapped for any other kind, e.g., a Manhattan apartment building for a Florida store or a West Virginia coal mine for a pier in Atlantic City. In May 1991, the IRS issued regulations that cleared the way for more elaborate real estate swaps involving middlemen referred to as thirdparty exchanges. Today, real estate divisions of certain brokerage firms specialize in matching property swappers around the country.

Use of Partnerships. A new device has begun to combine this significant tax break with another significant tax break. IRC section 721 allows partners to contribute property to their own partnerships without a capital gains tax. For example, a real estate investment trust ("REIT") forms a joint venture partnership with an operating partnership. A developer can exchange his or her property with the joint venture partnership, and the REIT can contribute cash it has raised in a public offering. …