In this article, I amgoing to explore 1031 exchanges and how they impact the car wash market. I’ll explain what they are, how to execute them, and how they can impact your thought process on whether to sell your car wash site or chain.
Basically, a 1031 exchange is when you sell property and defer capital gains or losses that you would otherwise have to realize (i.e., pay taxes on the gains) at the time of selling that property. A 1031 exchange is named after the section of the Internal Revenue Code that defines it (26 U.S.C. § 1031, for anyone nerdy like me who wants to read the statute). It reads, in relevant part, “(n)o gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
You must apply the proceeds toward “like-kind” property.
The public policy behind Section 1031 is to defer taxes on ongoing investments in property to encourage active reinvestment. You may also hear people refer to a 1031 exchange as a “Starker Exchange.” Even though 1031 exchanges have been around since 1921, it was not until 1979 when the court in Starker v. United States held that taxpayers could perform a tax-deferred exchange of property over a period of time rather than only doing so simultaneously. Since in the Starker case the exchange occurred over several years, Congress passed legislation limiting qualifying exchanges to properties identified in 45 days of the sale and purchased in 180 days of the sale, as further discussed below, to get that money reinvested quickly.
There are different types of 1031 exchanges (often referred to as delayed exchanges, simultaneous exchanges, reverse exchanges, and construction/improvement exchanges). I won’t get into the details of all the different kinds and what they entail here. For purposes of this article, I’ll focus on the most common one, the delayed exchange, but if you’re considering this strategy, make sure you consult your advisors to understand all your options.
So, what are the rules and time parameters for a 1031 exchange?
First of all, when you sell your property, you must apply the proceeds towards “like-kind” property. Exchanges work for personal property (e.g., artwork) and for real property (e.g., a car wash), but you cannot exchange personal property for real property (e.g., you cannot exchange artwork for a car wash). Section 1031 does not apply to certain things like stocks, bonds, and promissory notes, just to name a few. Something to keep in mind is that the real property in the exchange must be for business or investment purposes (i.e., you cannot use your personal residence or your vacation home). Also, real property in the United States cannot be exchanged for real property outside the United States.
Another rule is that the property you are acquiring must be of equal or greater value. If it isnot, the difference between the value of the replacement property and the value of the property you sold will be taxed as boot (sometimes called cash boot if the difference is paid in cash). A fun fact for you is that the term boot came from the good old days when people were trading horses or cattle and one person’s trade was worth more than the other person’s trade so the other person had to add cash (or something else of value) to the trade to make it happen; if it was cash, the person receiving the cash put it in his boot as he walked away with his less-valuable horse/cattle.
You must use a qualified intermediary for your transaction.
There are also some timing and other rules to keep in mind when engaging in a 1031 exchange. You must identify a replacement property for the property you are selling within 45 days after you sell your property and you must also close on an identified property within 180 days (remember, 180 days, not six months) of the sale of your property. The good news is that you can identify more than one property. You can identify up to three replacement properties to purchase regardless of their market value and you only have to close on one of them — often referred to as the “Three Property Rule.” You can identify unlimited replacement properties as long as their combined value is not greater than 200 percent of the property you are selling — often referred to as the “200 Percent Rule.” You can also identify more than three properties and the properties identified can exceed 200 percent of the property you are selling if you acquire 95 percent or more of the total value of the properties you identified — often referred to as the “95 Percent Rule.” To “identify” a property, you must, in a written, signed document that is hand-delivered, mailed, telecopied, or otherwise sent before the end of the identification period to the qualified intermediary (or another qualifying party), unambiguously describe each potential replacement property, such as by using the legal description, parcel number, or street address.
Maximize the benefits of the sale with a 1031.
Without getting into too much detail here, there are a few technical points for you to be aware of that you should discuss with your advisors:
1. You can have a mortgage on the property you’re selling and/or the property you are acquiring, but you must factor it into the calculation so as to avoid mortgage boot (or additional value you receive if the mortgage balance on the replacement property is less than the mortgage balance on the property you sold), or you could be taxed on it just as you can be taxed on cash boot as discussed above.
2. Certain expenses (e.g., qualified intermediary fees, real estate advisor’s commissions, attorney’s fees, tax advisor’s fees, escrow/title fees) can be paid with exchange funds, and certain expenses (e.g., property taxes, costs of financing) cannot be paid with exchange funds.
3. You can do a 1031 exchange for real property owned in an LLC/partnership where some of the owners want to do a 1031 exchange and others do not (the process is known in the industry as a “drop and swap” — converting an LLC/partnership interest to a tenancy in common or “TIC” before the sale of the property).
4. You can avoid depreciation recapture on the property you are selling (of course, you can’t depreciate land, but you can depreciate the improvements to the land), but only if you are purchasing an improved property (remember, a “like-kind” property) in the exchange (i.e., you cannot exchange improved land with a building for unimproved land without a building without recapturing the depreciation as ordinary income).
5. You must use a qualified intermediary for your transaction, which is a person who holds the proceeds for you from the time of the sale of your property until you apply them to the purchase of your replacement property since you are not allowed to take control of your sale proceeds during that time. Note that it can’t be someone who acted as your agent (e.g., your real estate advisor, your legal or tax advisor, your banker, etc., but any one of those individuals should be able to refer you to a qualified intermediary).
WHY DO A 1031 EXCHANGE?
So, why consider a 1031 exchange when deciding whether to sell your car wash site or chain? Even though you may not want to sell because you’re worried about being able to replace the income your sites produce, you may nonetheless want to sell because valuations are very frothy these days, because of fears of rising interest rates, inflation, or even a possible recession, because you fear another car wash developer/operator could build next to your site or sites and erode your value, or simply because you may not want to be an operator any longer and you want to retire (or need to for health reasons). If you choose to sell, you are going to want to maximize the benefits of the sale. This is when the 1031 exchange comes into the picture. If you don’t need the cash proceeds from the sale, you can use the entire amount (tax-deferred, not tax-free — but see below) to purchase income-producing real estate as a source of income for what could be decades to come, not to mention the increase in value you will receive from the property you purchase.
If you’re going to go down the route of buying income-producing property after selling your real estate, why not put all the sale proceeds to work for you, including the money you would otherwise pay in tax if you didn’t employ the 1031 strategy. And without getting into the tax weeds here, if you still own the property you purchased in the exchange when you pass away, the basis in that property will be “stepped up” to the fair market value of that property on your death, which could effectively eliminate the taxes on the gain that you deferred at the time of the exchange and the gain that you achieved since the time of the exchange, thereby entirely eliminating the gain you originally deferred after receiving the benefit from it all the while.
Find replacement properties well in advance of the sale.
To maximize this strategy, you first need to make sure you get top dollar for your site/chain, so make sure you hire the right advisor. Next, you need to get the best value replacement property for your investment moving forward so make sure you are doing your homework on finding replacement properties well in advance of the sale of your property as your negotiating power will be hindered if a seller of a property you want to identify knows you are under time constraints and/or you don’t have any other properties identified. Also, if you are purchasing a property in a sale-leaseback transaction from an existing operator, as I more thoroughly discussed in an article in the May 2022 issue of Auto Laundry News, in addition to the purchase price value, make sure you consider the track record of the operator, the strength of the operator’s lease guaranty, the annual bumps in rental rates, etc.
In addition to having the right advisors for the sale of your car wash and purchase of a replacement investment property, make sure you have the right legal and tax advisors. And, finally, if you are considering this strategy, you may want to move quickly on it in case the current administration is successful in limiting the benefits of 1031 exchanges in the near future. As we all have heard, the current administration is trying to increase tax revenues as much as possible, not just by raising rates, but by limiting or eliminating tax-saving strategies, and the 1031 exchange tax strategy is definitely on its agenda.
Jordan Geotas is a partner with Ardent Advisory Group, a leading investment bank specializing in the sale of multi-site car wash chains. Jordan has almost 30 years of commercial real estate, legal, tax, and investment banking experience. You can contact Jordan at Jordan@ArdentAdvisoryGroup.com.