The Compounding Effect

The following post is a portion of an article written by Ronald Raitz and appearing in the Sept/Oct edition of Commercial Investment Real Estate, The official magazine of the CCIM.

When Albert Einstein was asked, “What is the most powerful force in the universe?” His reply was, “Compound interest.” People in the financial services industry understand the effects of compounding: For example, whether an investor starts funding an individual retirement account at age 20 or 40 results in a dramatically different retirement balance at age 59½. The simplest of illustrations — the “double the penny” example — further highlights the sometimes surprising benefits of compounding: A penny doubled every day for a month is worth only two cents on day two, but on day 31 it is worth $64 million. Compounding plus time can indeed produce impressive investment growth.

Potentially the most powerful benefit of a 1031 exchange, the compounding effect also is the most overlooked. The key to getting the highest compounding result is keeping all of the money working for the investor — not only now but also into the future. In an exchange, the amount of tax that otherwise would be paid is reinvested. The projected future value of the compounded yield on the deferred tax becomes very substantial over time.

Many real estate investors also add leverage, which significantly amplifies the compounding effect. For example, in 1988, an investor who possessed strong management skills sold a $1 million property that had a $200,000 basis. Without utilizing an exchange, the gain on the sale would have been $800,000 with approximately $200,000 in taxes due. After paying the taxes, there would have been approximately $800,000 after-tax cash to reinvest.

But the investor exchanged the property and bought a $1 million income-producing replacement property that was 85 percent occupied. He put $200,000 down — exactly the same amount he otherwise would not have had without the exchange. Two years later, after making necessary management adjustments, he increased the property’s occupancy to 94 percent and sold it for $1.4 million. The $200,000 that he put down on the property (money that would have been used to pay the recognized gain in 1988) added to the $400,000 he just made equals $600,000.

The investor did another exchange and put the $600,000 in proceeds down on a $2 million income property that had been under-managed and was at 83 percent occupancy. Three years later, after achieving 92 percent occupancy in the property, the investor sold it for $2.6 million. With the $600,000 he had put down plus the $600,000 he made on the sale, after only five years the $200,000 tax that was deferred had grown to $1.2 million. Alternatively, without the exchange strategy the investor would have had no compounding benefit from his investments because the initial $200,000 would have been paid to cover the tax obligation.

Compounding combined with leverage can build wealth very quickly. Over a 12-year period, this investor did five exchanges and turned the money that he otherwise would not have had ($200,000) into $4.8 million.

Many investors have developed exchange strategies that have enabled them to go from a modest net worth to a very high net worth in a 10- to 20-year time frame. Clearly, these real-life examples are achieved more easily when real estate is in an up cycle, but this does not negate the potential benefits of employing a 1031 exchange strategy and holding real estate through the down cycles. Over time, the investors still come out far ahead of where they otherwise would have been if they had sold, paid the tax, and gone into an alternative investment.

Since there are no restrictions on the number of exchanges a taxpayer can complete, this strategy can be used during the taxpayer’s entire lifetime. Although some investors eventually sell property that is acquired via an exchange and pay the tax, it is very common to never cash out and carry investments into the taxpayer’s estate. At that point, the estate receives a stepped-up basis and the tax consequence disappears.

Section 721 Exchange into an UPREIT

A REIT is a Real Estate Investment Trust whose stock is publically traded. An UPREIT is a real estate investment operating partnership in which the REIT is the general partner and real estate investors are limited partners. A Section 721 Exchange is the method by which real estate investors can transfer a real estate investment into an UPREIT tax-free (or tax-deferred). Internal Revenue Code Section 721 deals with contributions of real estate to an operating partnership in exchange for an interest in the partnership.

UPREITs use IRC §721 to acquire property from investors who want to exchange out of their real estate investment into an investment which is managed by professionals. Subsequently, at a point in time which is suitable for the investor, UPREIT partnership ownership units are exchanged for shares for publically traded stock in the REIT which are then sold on the securities market. The exchange of units of the UPREIT operating partnership for stock shares in the REIT is a taxable event. But this is done at the same time that the REIT stock shares are sold so at this time the investor is cashing out of all or part of his investment at capital gains rates. This arrangement provides professional management and liquidity to the real estate investor.

In order to contribute an investment property to an UPREIT, the property must meet the REIT's investment criteria which generally include a requirement for institutional-grade property. If the real estate investor's real estate is not institutional-grade, he can convert his real estate to institutional-grade real estate with a sale and exchange through IRC §1031 and replacement with an investment in a syndicated tenancy-in-common (TIC) investment. Then, the TIC investment can be contributed to the UPREIT in exchange for ownership units in the operating partnership of the UPREIT.