Can Commercial Real Estate Solve the Housing Crisis?

America is in the midst of a summer of recovery. While there’s still a way to go before we fully return to normal, millions of people are returning to their pre-pandemic way of life. People are gathering with friends and family again. They’re getting on planes and taking trips. Bars, restaurants, gyms, movie theaters, and even concert venues are reopening.     

Unfortunately, there are a lot of businesses that won’t be welcoming people back. Thousands of businesses in retail, dining, and hospitality had to permanently close their doors because of the pandemic. In addition to those spaces sitting empty, there’s a whole sector whose usefulness has been upended by the pandemic: office space. Some employers have shifted to partial work from home setups, while others aren’t requiring their employees to return at all. As a result, there is a saturation of available commercial real estate, while at the same time there is historically low inventory for residential real estate. On its surface, the solution looks simple: turn all of the unused space into housing. Crisis solved, right?

Unfortunately, there are some challenges to making this a reality. Transforming commercial real estate requires planning, a lot of capital, and in many cases, a local government that is favorable to the process. One of the major challenges of converting commercial real estate into housing is zoning laws. If the zoning for a building doesn’t permit residential use, the property owner has to apply for a zoning variance, which is a special permit to build something that doesn’t conform to the letter of the law. The process for this is fairly involved and there is no guarantee that it will work. The other option is to request rezoning. While this is an even greater uphill battle than requesting a zoning variance, some communities may be flexible on these regulations in the face of long-term commercial vacancies.

New York City: A Test Case

No US city has been more impacted by closures than New York City, where space is always at a premium. In addition to the shops and restaurants that were forced to close, more than 17 percent of Manhattan’s office space was vacant as of March of this year. As a result, New York is becoming a test case for efforts to transform commercial space into residential.

John Cetra, a co-founder of the New York firm CetraRuddy, has overseen numerous conversion projects throughout his career. According to Cetra, a common hurdle when converting office space to residential is the size of each floor. The distance from the building entrance to the elevator, referred to as a “lease span,” needs to be a certain size for the conversion to work. According to Cetra, a span of 30 feet is ideal. When it’s greater than that, sections of the new residence won’t have windows or any outdoor light. Even in buildings where the floor size is ideal, the costs on conversions can run high. Things like installing showers and kitchens can require an overhaul of a building’s plumbing and electrical systems.

It remains to be seen how long this commercial real estate slump will last. Currently, owners of vacant commercial real estate may be weighing their options, wondering how much longer they can afford to have their properties sit empty and whether it would be worth the expense to start the process of conversion. That’s assuming, of course, that there wouldn’t be any conflicts with the local zoning laws.

In New York, the government is starting to find ways to respond to the housing shortage. The state assembly recently passed a bill which would earmark $100 million for converting distressed hotels and office properties into affordable housing. (It’s currently awaiting the governor’s approval.) With a surplus of commercial real estate and a housing shortage in all fifty states, New York’s solution might become the norm in other markets. 

Understanding 1031 Exchanges

One of the strongest tools for minimizing a real estate investor’s tax liability is the 1031 exchange. The 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows investors to avoid paying capital gains taxes when they sell a property and reinvest the proceeds into a new property or properties of like kind and equal or greater value. But how do 1031 exchanges actually work? Let’s take a look.

The overwhelming majority of 1031 exchanges are delayed, three-party exchanges. Delayed exchanges require a qualified intermediary, which is a person or business who holds the cash after you sell your property and uses those funds to buy the replacement property for you.

In order to reap the rewards of a 1031 exchange, the transaction must be completed in a certain timeline:

45-Day Rule

After you’ve sold your property, your intermediary will receive the proceeds from the sale. The seller cannot personally receive the funds, or it will invalidate the 1031 exchange. The seller has 45 days from the day of the sale to designate the replacement property in writing to the intermediary, specifying the property you want to acquire. The good news is that if you’re still uncertain which property you’re purchasing next, you can buy yourself a little time by designating up to three different properties. You are only required to close on one of them.

180-Day Rule

You must close on the new property within 180 days of the sale of the previous property. It’s important to note that the 180-day period starts as soon as the first sale closes. The 45-day and the 180-day periods run concurrently. If there is any money left after the purchase of the new property, the intermediary will pay it to you at the end of the 180 days. That additional income, referred to as “boot,” will be taxed as a capital gain.

Qualified Intermediaries

As we mentioned above, a qualified intermediary sells your investment property on your behalf, buys the replacement asset, and then transfers the deed to you. The intermediary is responsible for holding the money from the sale, preparing any related legal documents, and ensuring that the transaction is completed within IRS guidelines. The exchange agreement must expressly limit the investor’s rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property held by the qualified intermediary.

So who exactly are these qualified intermediaries? First, we’ll specify who the qualified intermediaries are not. You cannot act as your own intermediary, nor can you enlist a parent, sibling, or one of your children to act as your QI. In addition to family members, the IRS section 1031 bars anyone who has acted as your “agent” in the past two years from acting as your QI. The term “agent” is applied broadly, and can include your attorney, your CPA, your real estate agent, or any employees.

Apart from the above restrictions, there aren’t any licensing or educational requirements necessary to be a qualified intermediary. But since 1031 exchanges are complex transactions involving a lot of money, it’s best to seek out someone who is experienced and knowledgeable. While your CPA, attorney, or real estate agent aren’t legally able to act as your qualified intermediary, they may be able to recommend a person or company that will act as your intermediary. There are many companies that exclusively handle 1031 exchanges, and now some major banks such as Wells Fargo offer qualified intermediary services.

The cost of a 1031 exchange

The fees for 1031 exchange services vary based on the property type and value, but the cost for a straightforward delayed exchange usually ranges from about $600 to $1,000. If more than one property is involved, you might pay an extra $350 per additional property. Given the amount you’ll save in a 1031 exchange, the cost of hiring a qualified intermediary will pay for itself many times over.

Note: MC Companies does not offer 1031 exchange or qualified intermediary services.