Ralph Mangiarelli Jr. has owned investment property for almost three decades, starting with a small building in Johnston that housed his produce store – he bought it in 1979 and built it out, then leased part of the space to a deli.
Over the years, Mangiarelli has bought more commercial and residential properties, earning healthy returns from the rents and from appreciation. But when he had a chance to sell some of his oldest holdings in 2005, the potential capital gains tax liability was about $350,000. He knew there was a way to avoid that cost: to “exchange” it for similar property of equal or greater value within 45 days of the closing. The problem was, Mangiarelli was not interested in investing and managing properties anymore. It was too big a hassle.
What he did instead – and it took him months to build up the courage – is something most real estate investors can only dream of. He bought a piece of Mission Square, an office building next to the Los Angeles Courthouse.
He also snatched up some luxury apartments in Houston and similar property in South Carolina, both in the kinds of buildings that are normally owned by insurance companies, pension funds and other institutional investors.
The way Mangiarelli did this was by combining two strategies: a so-called “1031 exchange” and a “tenant in common” arrangement to buy high-value real estate. The former has been a legal option for years, though it only really took hold as the market heated up and investors had big potential tax liabilities to try to get out of. The latter is still rare on the East Coast.
In Rhode Island, knowledge of both strategies is limited, though there are several Realtors, lawyers and accountants who can handle 1031s.
One of the pioneers in the field is attorney Charles J. Ajootian, who has been studying 1031s since the late 1990s.
A 1031 exchange involves more than just taking the proceeds of a real estate sale and using it to buy another piece of property within 45 days. To meet the requirements of federal law and regulations, you have to declare in advance that you plan to use the money to buy another property, and you have to assign an “exchange intermediary” who will get the proceeds, hold on to them on your behalf, and then release them to make the new purchase.
That is what Ajootian’s firm, 1031 Exchange Services Inc., does – along with providing expert advice to investors and their real estate agents, lawyers and accountants. It started out as a tiny niche, but it’s grown over the years, Ajootian said.
Nationally, the capital gains tax liability on property appreciation averages about 20 percent, Ajootian said – 15 percent in federal tax plus 5 percent in state tax (in Rhode Island, as of Jan. 1, the rate has dropped to 1.67 percent for property held for more than five years). That means that if you bought a building for $200,000 in 2003 and sell it for $300,000 today, you’ll owe $20,000. And in many markets, including parts of Rhode Island but especially in the West and the South, the gains have been far greater, creating huge demand for ways to avoid taxes.
“The amount of 1031 money in play has grown,” Ajootian said. In places where the strategy has been heavily used for years, such as California, the market for his specialty has matured, he said, but “in almost every other part of the country, the feeling is that there are still a lot of pockets” of untapped potential. “Everyone reports that there are lots of groups and individuals who say, ‘I’d never heard of this. My broker never told me.’ ”
That was the case for Mangiarelli, who said that his accountant didn’t really understand how 1031s worked. But he happened to know Ajootian and his expertise, so he consulted with him when he was preparing to sell his Johnston property.
Ajootian, in turn, connected him with Marco J. Capaldi, director of business development at 1031 Horizons in Newport, a firm with an even more specialized niche. Capaldi, a veteran investment broker, helps people looking to make a 1031 exchange find a suitable TIC deal.
TICs resemble the better-known real estate investment trusts (REITs), but they’re different in a crucial way: While in a REIT, you own a piece of a company that invests in real estate, in a TIC, you own the property directly, with other investors.
As Capaldi explained it, TIC deals are put together by large national companies that identify valuable and attractive properties, set up a deal – including financing as needed – and then offer investors an opportunity to buy in, usually with a minimum investment requirement.
For each deal, a detailed prospectus has to be prepared, with a description of the property and the deal structure, information about the revenue the property has been generating and estimates of future revenue, and a warning that you could lose your entire investment.
Very few TICs have been offered in Rhode Island; the best-known, which closed in early 2003, was for 111 Westminster St. in Providence, the former Industrial National Trust or “Superman” building, a $22.9 million deal that up to 34 co-owners were allowed to buy into.
The minimum investment allowed by Inland Real Estate Exchange Corp., which set up the deal, was $291,176. The plan was to hold on to the building for 10 years, with annual returns starting at 7.19 percent and growing slowly, and then sell the building at a profit.
That’s a fairly typical arrangement, Ajootian and Capaldi said. The properties are handpicked to ensure a solid stream of rental income; the goal is to have high but not necessarily full occupancy, good business tenants and long-term leases. High-end multi-family rental properties are also used in these deals, Capaldi noted, and the hold times for them can be shorter because sometimes the appreciation makes it worthwhile to resell soon.
TICs’ popularity has skyrocketed since 2002, when the U.S. Internal Revenue Service ruled that buying into a TIC was acceptable for a 1031 exchange, Ajootian said. Since then, the volume of TIC deals nationally has grown from about $800 million in 2002 to nearly $6 billion last year.
The threshold to buy into TICs has been dropping, Capaldi said, to as little as $100,000 for deals involving as many as 100 investors. But typical investors are still high-net-worth individuals, he said – especially people in their late 50s or older.
“It’s a big change for people,” he said, “but it gives them the chance to upgrade their holdings. Maybe at one time or another they would’ve loved to own the CVS location that opened up around the corner .… Now they can sell their properties and get into a portion of one of those types of properties anywhere in the country.”
It’s a radical enough change that investors can be afraid to make the leap. Mangiarelli was so nervous when he started that he canceled a trip to Denver to buy into his first TIC as he was driving to the airport. But he later changed his mind, and after a year and he has no regrets.
“It’s a slower, more conservative deal” than buying and flipping properties, he noted, but that’s not as profitable as it used to be.
“And for retirement, I think, it’s a damned good way to go.”
