The Art of The 1031 Exchange

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Increasing your commissions by initiating 1031 exchange with clients can be as easy as taking candy from a baby. So why don’t more agents suggest it to their clients? Most just don’t understand it well enough, experts agree.

Typically when one of your clients sells investment property, he must report gain or loss in that sale. A 1031 exchange allows your client to defer his tax liabilities on the sale of property by re-investing the proceeds of the sale in another property of the same or greater value.

Such tax liabilities can include a federal capital gains tax, potential state income tax (a non-issue in Florida) and potential depreciation recapture taxes. The exchange increases the availability of money for your client, allowing him to invest into better property of equal or greater value. In effect, it’s an interest-free loan for your client from the federal government, in the amount he would have paid in taxes. And as an agent, you stand to make commissions off of at least two sales, rather than just one.

And, while it may sound too good to be true, 1031 exchange has been perfectly legal in the eyes of the IRS since the 1920s, according to the Internal Revenue Code Section 1031. Though there are some minor strings attached, knowing the basics can put you in line to increase both your earnings and your client base.

The first order of business is for you to identify a qualified intermediary associate for future exchanges, says 30-year veteran Stephen Wayner, first VP of Bayview Financial Exchange Service. Wayner presents 1031 exchange seminars to Realtors, attorneys and CPAs across the country, stressing the importance of selecting a reliable intermediary.

Such an independent intermediary is a must, as the law requires an independent agent to facilitate the 1031 exchange. Neither the client’s attorney nor accountant can serve as intermediary for the exchange, as the intermediary is essentially assigned rights in the sale contract for the property being sold as well as the contract for the property being purchased.

“If an agent has had a good experience with an intermediary, they should make the suggestion to their client; it will make the transaction smooth,” says Melissa Rubin, VP of Platinum Properties. “Most importantly, make sure the intermediary gives detailed advice as to how the exchange works. That takes the agent out of the advice arena.”

In addition, the intermediary guides the entire process and provides appropriate documentation throughout the exchange. However, the intermediary cannot provide tax, legal or financial advice to those involved in the exchange, even though he basically serves as the legal vehicle for moving the transaction forward. Keep in mind that intermediaries are not monitored like most financial companies; they are self-regulated and not overseen by the federal government.

“As an agent, I can help the client understand the benefits of the exchange and how he can make use of it, but I do not get involved in handling the exchange myself,” says Realtor Andrew James of Andrew James Realty in Miami, who estimates about 1 percent of agents are knowledgeable about the 1031 exchange process. “You could be held liable.”

Another rule that can hang the inexperienced out to dry and send the IRS laughing all the way to the bank is the timing rule, the crux of the 1031 exchange. The client must specifically identify in writing to the intermediary a property to purchase within 45 days of the closing on the property being sold. In addition, the client must close on the new property within 180 days of the date of the closing on the old property.

“The IRS has very strict compliance with their rules and regulations, and there is certain language that has to be in these contracts,” says Thomas Ringel, Esq. of Markowitz, Davis, Ringel & Trusty, P.A. “They like to see that language, because it lets them realize that the person who drafted the contract knows what they are doing and that helps things go smoothly.”

There are no extensions, with the exception of natural disasters as part of a relief package Congress recently passed. And while there is no penalty for not meeting the requirements, failure to do so would find your client having to pay the taxes after all.

Many people use the 1031 exchange process as a means to diversify investments. To qualify for an exchange, the Internal Revenue code stipulates that the properties must be held for use in trade or business, such as farmland, office space, an industrial building, warehouse or for investment, including rental property, such as condos and apartments or raw land. Also, 1031 exchanges are only applicable to property located within the United States and the U.S. Virgin Islands; foreign properties do not qualify.All of these property types are considered “like kind” under the code and can be exchanged for one another. A qualified property does not have to be exchanged for an identical type of qualified property. For example, a condo can be exchanged for raw land, or a warehouse can be exchanged for an office building. However, all sale equity from the first property must be reinvested in the replacement property. In addition, the client’s residential property does not qualify for 1031 exchange.

However, because Miami is such an international city, the question often arises as to the legality of Foreign Nationals being able to use 1031 exchanges. It can be done, but with a few additional strings, as they need to buy their properties in a C corporation that can handle the exchange. The Foreign Investment Real Property Tax Act (FIRPTA) forbids the individual from such a transaction.

“Accordingly, for foreigners investing in real property, forming a C corporation may result in higher short-term taxes while owning the property but will allow the client to take advantage of the deferred exchange and ultimately FIRPTA,” says Rubin, who suggests Foreign Nationals consult an accountant or tax attorney for new and creative tax planning strategies.

Developers are excluded from using the exchange on inventory and the exchange cannot be used to “flip” properties. However, 1031 does allow for the exchange of contracts of buildings yet to be constructed, though the timing must be just right, says Wayner.

Because South Florida commercial real estate values have gone up 25 percent to 30 percent each year for the past three years, investors are making a lot of money in real estate, and their capital gains would be very high, adds Ringel. “There’s always going to be an ‘end of the day,’ and you’re going to pay the piper, but you can keep rolling it over,” he says.

Though little has changed regarding 1031 exchanges in recent years, hearings scheduled for June in Washington will focus on one aspect of 1031 exchanges: 468b. The issue doesn’t affect the taxpayer, but does impact the intermediary as it concerns how the money is held in these transactions.

“Changes are a part of every tax exemption,” says James. “It’s politics. There were major changes in 1979 and again in 1991. They were positive changes for investors, with ‘like-kind’ taking on a broader definition. But depending on our next president, things can change very quickly, and we might not have this luxury for long.”

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