What Are Exchanges?
Every year, real estate owners and investors pay billions in unnecessary dollars to the government as capital gains tax on real estate sales. Either taxpayers and their professional advisors didn’t know enough about tax-deferred exchanges to even consider the technique, or what they knew was incorrect or incomplete and therefore this option was rejected.
In 1997, Congress passed new, generous rules that effectively eliminated capital gains tax on the sale of most people’s primary residence. But sales of other classifications of real estate (investment property, business property, vacation home, etc.) will be taxed on their profit unless buyers use the IRS Section 1031 Exchange Rule. (These transactions are often called tax-deferred exchanges or Starker exchanges.)
By using Section 1031, a person sells their existing non-primary residential property, follows the prescribed rules for handling the sale proceeds, and then reinvests these proceeds in a new purchase of an equal or greater value. This technique will not trigger any gain for tax purposes. Any tax is postponed.
Don’t think of this as an "exchange" (the term "exchange" is unnecessarily confusing). It is a "sale and new purchase" that are linked by a "legal fiction" that is called an "exchange." The sale and new purchase are interdependent. The simplest label to give this technique is "The Investment Roll-Over Rule." Think of this technique as being a "first cousin" to the well-known former "Residential Roll-Over Rule" (formally Section 1034). The only noticeable difference is that the time period is shorter" six months instead of two years. And the two events (sale and subsequent purchase) are linked together with special paperwork and treatment of the sale proceeds.
How is the title industry involved? Prospective exchangors and their advisors have historically looked to title agencies to help them with their exchange needs.
Section 1031 has been in the tax code for decades. In the Dark Ages, exchanges were furtively practiced by the very wealthy and small cliques of exchange-savvy investors on the West Coast. Exchanges were simultaneous. The exchangor (taxpayer) transferred the relinquished property and acquired the replacement property at the same time.
The landmark case, Starker vs. United States (9th Cir. 1979), dramatically changed the prevailing modus operandi. By sanctioning an expanded time envelope, the relinquished property could be transferred immediately and the replacement acquisition delayed until a future date. This ruling considerably expanded the desirability and usefulness of the technique and opened the floodgates for its use. The Internal Revenue Service finally acquiesced to this expanded use by codifying a delayed exchange in the Tax Reform Act of 1984. Specific mechanical rules for doing exchanges and "safe harbors" to induce their use, were then promulgated in 1991. When done correctly, a Starker exchange is a totally approved, code-sanctioned, tax-avoidance technique.
Section 1031 in Plain English
Here’s a translation in one paragraph. If you sell a property and correctly reinvest the proceeds in a new purchase of equal or greater value, you don’t have to pay any tax at this time. Both the property you start with and the one you end up with must be for your business or investment. Both must be the same kind of property ("like-kind"). This doesn’t apply to inventory or dealer property (like a builder or developer). You have to "identify" the property you want to acquire by the 45th day after you closed on the initial property you sold. And, you must close on the new property within 180 days of the initial sale.
Most lay persons, and even many professional advisors, misunderstand the correct interpretation of "like-kind." This results in frequent failure to use the technique and the ensuing payment of unnecessary taxes. Common sense would seem to define the term narrowly when the exact opposite is true. (1031 can be used for certain other asset classifications. In these instances, the term "like-kind" is construed narrowly.) When the classification is real estate, "like-kind" means simply that" real estate!
The Key is a Qualified Intermediary
The 1991 Regulations created the role of qualified intermediary. The intermediary helps preserve the fiction of an exchange and solves the problem of actual receipt or constructive receipt of the sale proceeds. Most title companies have separate entities that will serve as qualified intermediaries.
Here’s how it works. The exchangor enters into an agreement with an intermediary. (Any special exchange relationship with the buyer or subsequent seller is unnecessary.) Even though the intermediary can instruct the parties to deed directly between themselves, the intricate intermediary paperwork preserves the fiction of an exchange by routing the transactions through the intermediary.
This agreement will also describe a trust or escrow mechanism for holding the sale proceeds between the sale and subsequent purchase. If the exchangor has actual or constructive receipt of the proceeds, then the legal conclusion must be that a sale took place, and hence a taxable event has occurred. Properly drafted intermediary paperwork is critical and defeats this problem.
The qualified intermediary cannot be a relative or a professional advisor with whom the exchangor has an ongoing relationship. It will usually be an arms-length, third-party who offers professional intermediary services and has not been disqualified by the 1991 rules.
To induce exchangors to use the procedures of the 1991 Regulations, the IRS created safe harbors for critical elements of their recommended methodology. The comfort that occurs from the use of safe harbors is obvious, but there is a sinister downside. Failure to correctly use safe harbors is almost certain to be fatal.
Safe harbors include the use of an intermediary, trusts and escrows for money safety, and a growth factor (interest) for the exchange funds. One does not obtain complete safe harbor for an exchange merely by using just one of the safe harbors. Some are optional and some are mandatory. All competent exchange practitioners agree that the use of a qualified intermediary and a constructive receipt-defeating mechanism are mandatory to reach safe harbor. An exchange that does not use an intermediary and an accompanying agreement containing specific language will be "dead on arrival" in the event of an audit. An attempted exchange that only uses a trust or escrow safe harbor, and not an intermediary too, is fatally flawed. Foolish people who attempt a "Do-it-Yourself" exchange will learn this lesson the hard way!
Exchanges Must Meet Three Criteria
The replacement property (new acquisition) must have a value equal to, or greater than, the transferred property (net purchase price vs. net selling price). It is not enough that the equity be equal or greater.
The exchangor must not have "debt relief." If a mortgage is retired or assumed with the sale of the transferred property, then a mortgage of an equal or greater amount must be assumed or placed on the acquired property. If it is less, this is called "debt relief," which the IRS considers to be income, and the exchangor will be taxed on this difference. However, the debt relief can be canceled or off-set if the exchangor puts new cash into the purchase of an amount at least equal to the debt relief.
The exchangor must use all of the proceeds money from the transferred property to acquire the replacement property. If the exchangor retains any of the cash proceeds after the exchange has been completed, tax will be owed on this money that is kept.
More Opportunities Than You May Realize
Certain exchange opportunities may be obvious, but this technique has broader use than many imagine. You should print the following sentence indelibly into your brain. Every sale that is not a sale of the seller’s personal residence, is a potential exchange! The scope of this article does not permit a detailed analysis of this assertion, but my decade-plus experience doing exchanges has shown this to be true.
For example, taxpayers are aggressively using the exchange technique on vacation homes (second homes) everyday. Even builders and developers have the right to also be real estate investors" if they can document an investment use for the property. Bottom line: never assume the exchange technique is inappropriate.
Why Aren’t More Exchanges Happening?
We have analyzed and observed and have concluded there are three primary reasons prospects forgo using the technique. And the sad thing is, all of them have workable solutions.
The exchange technique largely remains a secret. People either don’t know about it, or what they think they know is incorrect! There are many myths and misunderstandings about exchanges. Many people insist on believing they are difficult when in fact, they are not.
I’m sorry to say that many professionals simply don’t know what they should. Admittedly, it may not make sense to become an expert in something one does only occasionally, but considering the technique’s potential usefulness, any professional ought to have an accurate, rudimentary working knowledge. Minimally, they ought to recognize an exchange opportunity when they trip over it in the dark. I suspect many professionals take a passive approach to the subject. A passive approach simply isn’t good enough. Exchanges can’t be treated as an afterthought. Professionals need to take a proactive stance about the exchange technique because of its great benefits.
When distilled to its essence, there is nothing difficult about most exchanges. (Sell then buy" rolling over your money with the proper paperwork and timing.) When you are explaining or discussing the exchange technique with a client or prospect , stay focused on two watch words" simplify and demystify.
The Prospective Exchangor Needs Money
Sometimes a seller has a compelling need for the sale proceeds. There may be no choice, but the "price" of accessing this money will be to pay taxes. However, the exchange technique is not "all or nothing." There are ways to access some money" and possibly not even pay taxes.
One strategy is to initiate the exchange, purchase the replacement property, but not use all the money in the exchange account. Once the exchange is completed (but not before), this money can be taken"but it will be taxable. This gives the exchangor the option of taking only what is needed (and paying taxes only on that amount) and sheltering most of the capital gains.
A more creative alternative is to perform the exchange, exactly as the rules require, putting all the equity into the new property. Then when the exchange is completed, borrow some of the equity with a commercial loan. Loan proceeds are not taxable and tenants effectively repay the loan with their rent. What a concept" borrow money and have others repay it! However, do not try to pull equity out of a property just before it is sold. There is an unfavorable ruling about that process.
The key is to examine what a client’s true needs may be and develop the appropriate strategy. If it is mandatory to access all the money, so be it. But if only some of the money is truly needed, then there are tax favorable alternatives.
Most real estate investors tend to think only in terms of being an active landlord. And they usually pursue properties that require "hands-on management." But you may have a client who is tired of being a landlord. They want out" even if the price of that exit strategy is paying taxes. They are a victim of "landlord burnout."
This scenario is now producing fascinating new products in the real estate marketplace. Investors can now purchase a percentage of the fee simple interest in commercial projects that have nationally known credit tenants, triple-net leasing, professional management, and double-digit returns. Owning this investment is totally passive. The owner gets a monthly check just like a CD or a Bond. The return is very attractive and competitive, no land lording or management is necessary" and all of that important equity is still intact!
The exchange technique offers compelling benefits and has more flexibility and opportunities for creativity than most imagine. The technique should be rejected only after careful analysis shows it cannot, in any way, meet the client’s needs.
Once a sale takes place, and if the exchange technique has not been initiated, the game is over. A taxable event has now occurred. The spilled milk cannot be put back in the bottle. If there is even a remote chance the client may want to do an exchange, preserve the option by initiating an exchange at the closing. (The cost of the exchange, as an insurance premium compared to the tax liability, is a small price to pay.) The client can always call it off later if they like, receive their money, and simply have a taxable event (which is what would happen anyway). Keep their options open!
Offering this ancillary service, and helping save clients unnecessary taxes, will generate infinite good will and positive "word-of-mouth" advertising for your title business.
John Galley, Esq., is CEO of the exchange intermediary company Title Agent’s Exchange Alliance (T.E.A.M.) located in Chicago, IL. He can be reached at email@example.com or 207-236-7400.