1031 Exchange in Denver Commercial Real Estate – A Jigsaw Puzzle

IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain on the sale of real estate if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. The six-month limit on the closing of the new property can become stressful if unexpected complications arise. This deal involved the sale and purchase of an apartment building, the sale of 17-properties, and the construction and sale of a 14-unit townhome project.

The Players

The players are interesting. The seller of the 30-unit apartment building with an adjacent 17,000 square foot empty lot was an elderly investor set in his ways. His name was Chad. The buyer, John, was a very smart and sophisticated real estate investor who has been generating a great reputation in the Denver market. The developer group of the 14-unit townhome project, Gemini, was composed of wealthy businessmen, my general contractor, and me.

This was a jigsaw puzzle of a deal. I am a commercial real estate developer and broker. I played both roles in this deal.

The History

In July, 2016 I was in the process of starting a 14-unit townhome project in Jefferson Park (28th Avenue & Elliot Street). The project was a “slot home” development with two seven-unit buildings facing each other. We called it “Gemini.” Our group had purchased a permitted project from an architect. We had planned to sell the individual units for a total sales price approaching $7m.

At the time we put Gemini on the market, we were finishing three other development projects. A real estate agent had seen a listing of one on MLS. This agent said her client, Chad, wanted three units from the project. I showed them the project and his reaction was “This is too expensive.” He had doubts that the market rents would generate the positive cash flow he wanted. We went to see another of our projects, “Streetcar,” and he thought that one was also too expensive. I then showed him our last project and he had the same opinion.

As I was showing Chad these properties, I listened carefully to what he was saying. I then met with him privately and listened to his ramblings for hours. What Chad really wanted was control of an entire building. He had a 30-unit apartment building in Glendale on a 31,000 square foot lot. He bought it sight unseen in a 1031 Exchange. Chad did not like the building, its location, the tenants, nor the property management company that was running it for him. He wanted out.

The building had a lot of deferred maintenance issues. The tenants were a bit of the gnarly type that kept the Glendale Police busy. The rents he was receiving were below market and the building had chronic vacancies.

The Transaction

Chad had listed the property with a commercial broker. He told the broker he wanted to net $3.7m. The broker listed it for $4m, expecting to generate a $300,000 commission. The building did not sell.

After I understood what his objectives were, I asked him if he would like to do a 1031 Exchange for our 14-unit townhome project, Gemini. He said, “Yes!” We went to work to put the deal together.

I listed Dexter $3.75m which included a $50,000 commission and I agreed that I would pay his closing costs. He also owned a six-unit property on Yale Avenue for which he wanted to net $1.65m.

I made a few phone calls and sold Dexter. Our development group needed a year to build the new building, Gemini. Chad could not close on the sale of Dexter to John since we still had to build Gemini and the two of them agreed on a one-year close and a one-year lease of Dexter to John. Within that year, John remodeled the units, raised the rents and found new tenants. He was paying $15K per month to Chad and generating $30K per month in income. He invested $400K to remodel the units.

The purchase contract written by our attorney was difficult for Chad to accept. The first thing he wanted, and rightly so, was a definite completion date. This we could not guarantee because of the chronic uncertainty provided by the city of Denver and Xcel Energy. This uncertainty caused issues with 1031 timeline.

When you are a seller of a property you are at a disadvantage with the buyer because of the protection afforded purchasers by Colorado law. Chad could not back out had to complete the sale to John. Negotiations on price took 30-days as did those on the terms of the purchase contract.

The deadline for the 1031 Exchange for Chad was six months from the execution of the contract for the sale and purchase of Dexter. On September 30, 2017 the Dexter sale closed. This began the 180-days period for Chad. He had to close on the purchase of Gemini by close by end of March, 2018.

Complications

As we progressed toward construction completion we encountered regulatory snafus presented by Denver that were putting that March closing date at risk. In addition, Chad’s two properties were under two different legal entities. The revenue from those sales, according to the 1031 regulations, had to come from the same legal entities. Chad had failed to advise anyone of this complication. Since the Yale property legal entity was different from the Dexter legal entity we had to separate four units in Gemini into another transaction and used the proceeds from the Yale legal entity to purchase those four.

The Opportunity in the Dexter Deal

As I mentioned earlier, the Dexter property was rundown, had significant vacancies, bad tenants, and to cap it all off Chad had no financials on his property. Instead of viewing that as a negative, John saw that as an opportunity. He negotiated a purchase price at about a 5.5% cap rate. He invested $8,000-12,000 per unit and increased rents from $600-$700 to $900-1100 per month. John saw the value play there.

After the improvements, John had the property appraised and the valuation was $4.8m. Remember, John paid $3.75m ($1.25m down and $400,000 in improvements) for the property.

Dexter was located in a SMX 8 zone which means suburban mixed use, 8-stories, providing John with lots of alternatives for the lot that lies west of the apartment building, a 17,000 square foot parking lot. I priced it at $1.2m after running a proforma on a condo building and worked backwards and my conservative calculations brought the price for the dirt at $75 psf. John had the property surveyed and put a property line five feet (zone lot amendment) to the west of the building. This change in the amount of land under the building did not change its appraised value of $4.8m. I listed the building and the land for $6m. We are in the final phases of negotiation for the sale.

There is one more complicating factor. The adjacent lot must have 28-parking spaces. Regulations require 1.25 parking spaces per unit or 38 spaces. However, if one allows Car 2Go to use the parking spaces you get a five to one credit for each space designated to their use. We gave two spaces to Car2Go which means the parking lot must provide the building with 28-spaces.

At the price for $4.8m for the building it would generate a 5.2% cap with its $376,000 annual rent. If John sold the lot for $1.2m, his basis in the building would be $2.9m. and an 8% cap rate. With a $1.350m cash investment, John will make $1.7m in 12-months.

As far as our profit on the Gemini project is concerned, we made a 50% return on our cash invested. We bought the property entitled with all permits. Our normal target is to make 80-100% on cash. With Gemini we made 50%. We calculated that the additional cost of the entitled project versus the risks associated with starting from zero and the time that would entail pushed us toward reducing our expected profit. Some of our investors were concerned about the late-market cycle risks. Cutting the deal cycle time was critical.

Chad bought Gemini. Three months later, it is fully leased. Has $500K profit now if he were to sell it fully leased.

He is looking for another project.

APOD (Annual Property Operating Data)

Download the before APOD by clicking here.

Download the after APOD by clicking here. 

Take-aways

  • Know 1031 timeline; the process is a valuable tool. Take advantage of it.
  • Communicate openly and frequently about all aspects of the deal, especially those that might impact the eligibility of the 1031 Exchange
  • Good property management makes a big difference
  • Don’t ever give a guaranteed completion date
  • Don’t 1031 into new construction

Conclusion

If you need help juggling a complicated 1031 deal, give me a call. I’ll lay it all out for you in simple, easy-to-understand terms.

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