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contact David at david.hwa@timcorfinancial.com
1031 Tax Exchange also known as
The Delayed Exchange
The delayed exchange, also called
a Starker exchange, is a very special investment technique which can
only be used in real estate transactions. You are allowed to sell your property
today and to reinvest the profits as long as six months later without having
to pay the taxes due on the sale. Taxes are deferred to a future date that you
choose. The 1984 Tax Reform Act provided Congressional approval of the concept
of delayed exchanging by requiring that the investor identify his trade property
within 45 days and complete the exchange by 180 days after the sale of his property.
The 1986 Tax Reform Act increased capital gains taxes and is responsible for
a rapidly growing interest in the use of delayed as well as simultaneous exchanging.
The delayed exchange procedure was brought to the attention of the real estate
community when an investor by the name of T.J. Starker and his family attempted
to trade timberland to the Crown Zellerbach Corporation in exchange for a promise
to deliver suitable trade properties to the Starkers in the future. The I.R.S.
challenged this transaction and after a series of tax court trials, the 9th
Circuit Court of Appeals ruled in favor of Mr. Starker. The I.R.S was not happy.
As recently as March of 1988 they stated that the appellate decision applied
only to Mr. Starker and that the widespread use of delayed exchanges may create
problems for many investors. However, Regulations issued in 1991 validated the
used of the delayed exchange on a national basis.
The present forms of delayed exchanges rely heavily on the final Starker decision
of 1979. Unfortunately, the manner in which Mr. Starker accomplished his exchange
cannot be duplicated by the typical investor. Because of this, attorneys have
attempted to determine the underlying principles of the case and to construct
a procedure which approximates Mr. Starker's exchange procedure. There is significant
controversy over these various procedures and the investor is left without a
clear idea as to how to safely proceed with his delayed exchange.
Today's delayed exchanges use a Qualified Intermediary to assist in the trade.
The Qualified Intermediary is a principal in the exchange who accepts the exchangor's
property, sells it and then, at a later date, purchases the trade property and
transfers it to the exchangor. The exchangor gives his property to the Qualified
Intermediary and receives a property in trade. The transaction is a perfect
1031 exchange which occurs in two stages rather than one. The use of a Qualified
Intermediary provides greater opportunities for profit and for problems.
There are no guidelines or recommended exchange formats described in I.R.C.
Section 1031. The documents and agreements which are commonly used for simultaneous
exchanges have evolved over time until we now have several easily defensible
procedures available to perform concurrent exchanges. Before the 1991 Regulations
on exchanges, the delayed exchange was so new and had been used so infrequently
that no universally accepted procedures had been created to accomplish it. It
is clear, however, that the delayed exchange must be performed in exactly the
same manner (not time frame) as a simultaneous exchange and that every restriction
imposed on simultaneous exchanges must also be applied to delayed exchanging.
To have a proper delayed exchange, it is necessary for the Qualified Intermediary
to be a bona-fide principal in the transaction. The cash which the Qualified
Intermediary receives for the sale of the exchangor's real estate must become
the property of the Qualified Intermediary. The exchangor should have absolutely
no control of the proceeds from the sale. The transaction should include an
exchange agreement in which the disposition of the exchangor's property and
the acquisition of the trade property are interdependent. That is, the trade
out of the exchangor's property cannot take place without a requirement that
the exchangor receives a property in return.
Every exchange provides opportunities for wealth-building, but also provides
the opportunities for penalties in the event the exchange is performed incorrectly.
The delayed exchange is entirely legal, defensible, and has been used thousands
of times over the last ten years. However, it is imperative that the exchangor
and his agent obtain qualified, correct advice on the exchange before committing
to the transaction.
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Exchange Strategy
Investors buy real estate to earn
a profit. Decisions are carefully made to determine the effects of location,
potential rents and expenses, financing and a multitude of other important factors
in an attempt to realize as much of a profit as possible. Once the profit is
made, the typical investor sells his property, pays his taxes and reinvests
in other real estate. The vast majority of real estate investors seldom make
use of the wealth-building advantages of the tax deferred exchange.
Every investor knows that leverage
creates wealth. A 20% down payment can result in a 50% investment return because
of leverage. Tax deferment is also leverage. Just as you use financing to leverage
a purchase, you can use tax savings to acquire even greater wealth. The 40%
or more of capital gains taxes which normally would be paid to the Federal and
State government can now be used to acquire larger properties. An investor is
able to accelerate his investment program by eight years or more by carefully
developing an investment strategy utilizing exchanges.
Exchanges are useful in a wide
variety of circumstances. They provide excellent opportunities for resourceful
investors to create transactions which would not be possible through a sale/purchase
format. The overriding advantage of exchanging lies in the ability to move equity
from property to property without having to pay the capital gains taxes. Exchangors
can create an entire investment program using the wide variety of benefits available.
There are approximately 19 common exchange strategies and many more uncommon
uses of exchanging. These articles only deal with real estate exchanges but
business equipment can also be exchanged. The most common uses for exchanging
are:
- Exchanging from property which
cannot be refinanced, such as land, to improved property which will support
a new loan gives the client the ability to obtain cash. Trading from non-productive
land to improved property can also create cash flow.
- Trade from a high appreciation
property, such as a house or apartment, to a high cash flow property, such
as a retail store, or from a cash producer to one which generates more capital
appreciation.
- Exchange from a property with
high debt service payments for property with lower payments or lower interest.
- Exchange for a property that
is easier to sell.
- Exchange to change the lifestyle
of a client. For example, exchange for a property requiring no management
for the retiree who wishes to travel or move.
- Exchange from many smaller
properties to a larger building to consolidate ownership benefits or from
a larger building to smaller properties to improve liquidity or to divide
ownership among several persons.
- Trade to convert the nature
of the investment. For example, trade from an investment house to a small
medical building for the doctor who wishes to practice in a building he owns.
- Leases of 30 years or more
may be traded for real estate. Sale lease/backs have been ruled to be exchanges,
if done properly.
The uses of trading are limited
to the imagination of the investor and his advisor. Almost any problem can be
solved or objective reached more quickly by using the tax-deferred exchange.
For the beginning or experienced investor, a counsellor trained in real estate
investment and exchanging is invaluable for creating wealth.
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Your first Exchange
Building an Exchange
For many years, any real estate investor or practitioner who wanted to learn
how to perform exchanges had to read books or attend seminars which dealt with
how to do an exchange rather than how to use the procedure to make money. A
race car is a good analogy. There are race car mechanics and race car drivers.
The mechanics build and maintain the cars and the drivers drive them. It is
not necessary for the mechanics to know how to drive or for the drivers to know
how to build a race car. In the early days of racing, drivers had to be mechanics
because automobile racing was in its infancy and hadn?t become a specialized
business. The exchange business is very much the same. In the beginning, a real
estate agent or investor who wanted to do an exchange had to learn the mechanics
of the procedure and took responsibility for making the exchange "run."
Today, you just have to learn how to "drive."
Useless Information
Virtually every professional teaching exchanging talks or writes on how to do
an exchange. Instruction and information is related to how to be an exchange
mechanic. Court cases, recapitulating exchanges, legislation, exchange diagramming
and many other aspects of exchange mechanics are taught and quickly forgotten
by the end of the seminar. Even investment professionals at the highest level
of the business are numbed by the amount and complexity of information and swear
never to perform an exchange. This is unfortunate because any investor who sells
and buys real estate rather than exchanging never recovers the profits he has
lost.
Exchange Mechanics
Who are the "mechanics" of exchanging? Escrow companies, attorneys,
accountants, and, to a limited extent, real estate agents. Before 1979, real
estate agents specializing in exchanges were the master mechanics of the business.
They took the order and coordinated all of the activities required to build
the exchange. Since only a very few agents were able to master the mechanics
of the process, very few investors ever learned that exchanges were possible,
much less that they were absolutely necessary. When the famous Starker case
was decided in 1979 and delayed exchanges became a legal method for deferring
taxes, exchange facilitation companies were developed. These firms specialized
in performing all of the mechanics of an exchange and made the process available
to everyone.
Becoming a Driver
Exchangors can now be drivers. It is no longer necessary to know anything about
exchanging to use the procedure. A single telephone call to a qualified exchange
facilitator is sufficient to create an exchange of any complexity any place
in the nation. The majority of exchanges being performed today are through facilitation
companies. These specialists build the exchange and handle all of the problems
which may arise. Armed with the telephone number of a qualified facilitation
company, you are able to concentrate on winning the race to financial independence.
The First Exchange
In preparing for your first exchange, locate an exchange facilitation firm and
question them on their background. You can obtain the names of facilitators
from escrow companies and real estate agents. Facilitators should not be acting
as "agents" as well as facilitators. Attorneys, accountants, and real
estate agents, who have provided professional services to an exchangor are not
allowed to also perform the function of the facilitator for that particular
exchangor. Price is not a qualifier. If you are looking for a brain surgeon,
you do not shop on the basis of price. Exchange fees range from $500 to $1,200.
The difference in price is often the difference in service. You may wish to
obtain copies of the documents the facilitator will use for review by your attorney.
Once you are comfortable with the facilitator, follow their instructions to
a safe exchange.
Investing is a race against time:
You want to build your estate as quickly as possible. Find a good mechanic and
use the exchange to win your race.
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Choosing an intermediary
As we noted in previous articles,
every exchange which requires the sale of the exchangor's property requires
the use of an accommodator or "qualified intermediary". The accommodator
passes ownership and cash among the various parties to the transaction. The
accommodator may be the buyer of the exchangor's property, the owner of the
property the exchangor wishes to acquire, or an independent fourth party who
enters the transaction specifically to act as the accommodator. The use of a
fourth party to accommodate the exchange is referred to as a "facilitator
exchange". The facilitator exchange is rapidly becoming the exchange format
of choice since the other parties to the transaction do not have to assume additional
liabilities. In addition, the facilitator exchange provides the greatest degree
of flexibility in moving from one exchange format to another as circumstances
in the transaction change.
Qualified Intermediary
-- Defined
A qualified intermediary is a bona-fide principal in the transaction. He acts
for no other person's benefit but his own. His interests may, or should, be
in opposition to the exchangor's. He earns a profit from his participation in
the transaction and does not earn a fee for finding or negotiating the purchase
of the property the exchangor will receive. The qualified intermediary must
not be the exchangor's real estate agent, attorney, trustee or anyone else who
acts in a capacity which may be construed as agency.
Qualified Intermediary
-- Desired Traits
It is recommended that the qualified intermediary should not be a relative of
the exchangor. This relationship is too close to insure that the relative will
be considered an independent entity. The qualified intermediary should be a
corporation so that, in the event of injury, death or financial dissolution
of an officer of the corporation, another officer is empowered to complete the
exchange.
Given a choice, the qualified
intermediary selected should be one who adds strength to the exchange by providing
a wealth of experience and knowledge of investment real estate and exchange
procedures. The qualified intermediary should ideally own and operate investment
real estate. Additionally, they should be members of the Federation of Exchange
Accommodators. A qualified intermediary whose sole function is to enter the
exchange to "hold the money" cannot provide assistance when problems
arise. These individuals are nothing more than strawmen and their use subverts
the principles underlying I.R.C. 1031.
Securing the Sale Proceeds
In a delayed exchange, the sale proceeds from the sale of the exchangor's property
are normally transferred to the qualified intermediary pending the purchase
of the trade property, perhaps many weeks or months later. During this time,
the qualified intermediary is the legal owner of the cash. The exchangor no
longer has either his property or the cash from its sale. The exchangor has
a contract with the qualified intermediary to deliver a trade property sometime
in the future. The exchangor cannot exercise any control over the cash or he
may be considered to have constructive receipt of the funds and the exchange
would be disallowed.
There are many techniques being
touted which purport to secure the sale proceeds. Among the most common security
devices are semi and fully-fettered bank accounts (one or two parties needed
to withdraw funds), security agreements using the funds as collateral, creating
a corporation to enclose the funds, qualified escrow accounts, and stand-by
letters of credit. Above all, the strongest security is the integrity of the
qualified intermediary.
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Capital gains and 1031 legislation update
A proposal was unveiled by the
Treasury Department (in April) which affects tax-deferred, like-kind real estate
exchanges. This proposal would significantly narrow the types of real property
exchanges that now qualify for tax deferral by requiring that exchanged properties
be "similar or related in service or use" rather than "like-kind"
under current law. This new standard would, unquestionably, disqualify a wide
variety of real property exchanges.
What is now clear tax guidance
on like-kind property transactions would be replaced by great uncertainty over
whether future exchanges of raw land for improved real estate or office buildings
for multifamily apartments would be eligible for tax deferral. Properties would
have to be similar in physical characteristics and end uses to qualify. What
was a proposed simplification of the law, would confuse investors trying to
determine if a proposed exchange would qualify for tax deferral.
At this point in time, the tax
bills reported out of the House Ways & Means and Senate Finance Committees
do not include the Clinton Administration's proposal on IRC Section 1031. A
Congressional Conference Committee will be organized to work out the final details
of the competing tax bills. The Conference Committee could conceivably during
its deliberations include other tax provisions not previously considered like
1031. We will monitor the situation and let investors know what is finalized
when the Budget is agreed upon.
Capital Gains update:
As of June 20, 1997
A cut in capital gains taxes, reducing
the top rate to 20 percent, from 28 percent now, except for profits from real-estate
sales, which would be taxed at a maximum 26 percent. Real estate owners can look
for a $500,000 exclusion for each sale of a home that has been a principal residence
for two of the last 5 years.
More info on the web
www.1031it.com
About the Author:
Lonnie Nielson is the President of 1031 Real Estate Services, Inc. a California
Corporation. He serves on the Board of Directors for the Federation of Exchange
Accommodators. He is a Financial Planning graduate from Brigham Young University,
and has been counseling exchangors for 10 years. For additional information
on exchanges call 800-593-1031(nationwide).
Broker Note: We can
recommend Alpine Title from Gaylord Michigan as handling several of these type
of transactions for us and our clients and customers, ask for:
Vicki
May-Alpine Title Company
P.O.
Box 597 Gaylord, MI 49735
989-732-7562
(business) 989-732-6392 (fax)
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