Hospitality and 1031 Exchange

For hospitality owners, a 1031 transaction involves both personal property and real property.  They July issue of AAHOA sets forth the basic rules which govern the allocation of purchase price between real and personal property.  If more that 15% of the purchase price is allocated to personal property, the personal property must be separately identified.  For most selling hospitality owners, a 1031 transaction allows sellers to move to a bigger hotel, a better geographic market, a more prestigious flag, a more desirable climate, make the transition to a full service hotel or some combination of the foregoing. 

Hospitality owners who have a portfolio of properties also can use the 1031 exchange to diversify their holdings. While hospitality proprieties can be highly profitable in a favorable economic climate, owners may use a 1031 transaction to diversify their portfolio to other asset classes that offer lower returns with more consistent cash flow. 

Diversification can put hospitality owners in the enviable position of being able to buy additional hospitality properties when economic conditions in the hospitality market are not favorable to sellers.  Investing in liquid commercial real estate allow investors to buy on cyclical downturns that occur in the hospitality market (i.e., 9/11 or a general economic slow down).  Frequent assets bought for this purpose are national credit tenant triple net lease properties that cash flow through both good and bad economic times and require little to no management.

1031 Timing Strategy

In the present market, the most difficult aspect of a 1031 transaction is identifying replacement property within 45 days of the close of escrow.  There are several strategies used to effectively extend the 45 day identification period.

The simplest approach is arrange with the buyer of the property to have extension options to delay the closing of their escrow to allow extra time to seek replacement property.  Many buyers will allow an additional 30 to 90 days to close provided the extensions are part of the original negotiations.

Another approach is to do a reverse exchange.  In a reverse exchange, the 1031 investor first buys the replacement property then sells their relinquished property.  In a reverse exchange, the investor has 45 days from the close of their replacement property to identify the property they are going to sell (relinquished property) and 180 to complete the exchange.  Such and exchange require that the seller have additional cash to invest in the replacement property before selling their property. 

The precise timing of a hospitality sale also raises some very practical issues for hospitality buyers and sellers.  For hospitality properties with strong (or weak) seasonal income, the timing of a sale significantly affects the income of the seller and the buyer. 

As an example, a seller of a property located in a skiing area in the mountains would prefer to complete the sale in April just after the peak of the season and let the new owner take over the property before the slower summer and fall months. 

Conversely, the new buyer would like to complete the sale just before Thanksgiving to maximize the income during the first few months of ownership.  These timing issues must also be addressed on a 1031 transaction.

The timing of the close of the relinquished property should also carefully be considered.  General it is most advantages to close the sale of property immediately after the first of the year.   This way, even if the seller does not complete a 1031 transaction, the seller maximizes the deferral of capital gains and depreciation recapture tax liability until April 15 of the following tax year.  In order to complete a sale by the first of the year sellers need to actively market their property for sale during the late summer or early fall.

Sellers of hospitality property must also decide what class of property they will choose as replacement property.  The "like kind" requirements of a 1031 exchange allow investors to change asset classes.  Sellers can decide against the demands of hospitality ownership and can acquire triple net leased properties as replacement property.  Hospitality investors can also invest their proceeds into retail, office or industrial property. 

Since replacement properties must be identified within 45 days of closing, prudent buyers generally have their next property under contract and all due diligence and financing in place by the end of their 45 identification period.  The risk of not doing this is that if the sale is not consummated after the 45 days passes the investor cannot name another property.

Replacement of Debt

In a 1031 transaction, sellers must reinvest all their cash and replace any debt (mortgage) associated with the sold property.  In other words, if a hospitality owner sells a property for $2,500,000 and has a mortgage of $1,000,000 and closing costs of $100,000, the owner must buy a property for $2,400,000 or greater in a 1031 transaction. 

Is a 1031 Transaction for You

If you are a hospitality owner seeking a bigger property, a more prestigious flag, a better demographic market, a different geographic area or a bigger challenge, a 1031 transaction is for you.  A 1031 transaction is also an opportunity to leverage their existing equity and create additional income through positive leverage. 

Take the example of the investor who sells a property for $2,500,000 and nets $1,400,000 in cash and then reinvests in a $6,400,000 property with a cap rate of 12% and a new mortgage at 8.5% on $5,000,000.  The investor would earn 12% on their $1,400,000 or $168,000.  The investor would also generate additional income of 3.5% on $5,000,000 (the difference between the cap rate on the property and the interest rate on the loan.  This amount is $175,000.

The current debt market provides opportunities for hospitality investors.  Experienced hospitality investors generally obtain preferential rates and terms from lenders which allows the investor to earn a rate of return on equity provided by lenders.  Since hospitality investments are often highly leveraged, this helps investors generate additional cash flow.

By leveraging their equity, aggressive hospitality investors can also take advantage of an appreciating market.  A 10% increase in value on a $2,500,000 property is $250,000 while the same 10% increase on a $6,400,000 property is $640,000.  The investor needs to factor in the risk that the same leverage can go against them in a declining market.

Buying bigger assets also provides hospitality investors with traditional real estate tax benefits from increased depreciation expense (to the extent the 1031 investor buys an asset greater in value than the relinquished asset).  These tax benefits increase after tax yields.

A 1031 transaction provides hospitality owners with opportunities and challenges.   For hospitality owners seeking to generate more income from their existing equity, a 1031 transaction is a way to complete a tax free exchange of equity into a higher quality hospitality property.  Higher quality assets generate more revenue and creates more potential for long term gain. 

A 1031 transaction is also a way to leverage equity and take advantage of favorable treatment from lenders because of hospitality ownership experience.  Experienced and established hospitality owners can borrow at very favorable rates and create positive leverage in the present debt market.  The challenges lie in selling a property, finding a property and obtaining financing within the time limitations of a 1031 transaction.