General Information on Exchanges A 1031 exchange (tax-deferred exchange) is one of the most powerful tax deferral strategies remaining available for taxpayers. Anyone involved with advising or counseling real estate investors should know about tax-deferred exchanges, including real estate agents, lawyers, accountants, financial planners, tax advisors, escrow and closing agents, and lenders. Taxpayers should never have to pay income taxes on the sale of property if they intend to reinvest the proceeds in similar or like-kind property. 1031 ADVANTAGES: The Advantage of a 1031 Exchange is the ability of a taxpayer to sell income, investment or business property and replace with like-kind replacement property without having to pay federal income taxes on the transaction. A sale of property and subsequent purchase of a replacement property doesn't work, there must be an Exchange. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges. The IRS issued "safe-harbor" Regulations in 1991 which established approved procedures for exchanges under Code Section 1031. Prior to the issuance of these Regulations, exchanges were subject to challenge under examination on a variety of issues. With the issuance of the 1991 Regulations, tax-deferred exchanges became easier, affordable and safer than ever before. 1031 DISADVANTAGES: The Disadvantages of a Section 1031 Exchange include a reduced basis for depreciation in the replacement property. The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain which was deferred on the sale of the relinquished property as a result of the exchange. The replacement property thus includes a deferred gain that will be taxed in the future if the taxpayer cashes out of his investment.
EXCHANGE TECHNIQUES: There is more than one way to structure a tax-deferred exchange" under Section 1031 of the Internal Revenue Code. However, the 1991 "safe-harbor" Regulations established procedures which include the use of an Intermediary, direct deeding, the use of qualified escrow accounts for temporary holding of "exchange funds" and other procedures which now have the official blessing of the IRS. Therefore, it is desirable to structure exchanges so that they can be in harmony with the 1991 Regulations. As a result, exchanges commonly employ the services of an Intermediary with direct deeding. INTERMEDIARIES: Exchanges can also occur without the services of an Intermediary when parties to an exchange are willing to exchange deeds or if they are willing to enter into an Exchange Agreement with each other. However, two-party exchanges are rare since in the typical Section 1031 transaction, the seller of the replacement property is not the buyer of the taxpayer's relinquished property. Any person considering a 1031 exchange should ask the potential Qualified Intermediary a few questions: - Do you have a guarantee of funds? If yes, who is it from and is the guarantor profitable and solvent;
- Do you have a fidelity bond and are you insured for errors and omissions? Verification of insurance is available by obtaining a Certificate of Insurance which is issued by an independent third party (the authenticity of which can be verified by them);
- How are the exchange funds invested? Since the funds must be liquidated in a short period of time, they must be invested in a manner that is both liquid AND secure; and
- Does the Exchange Agreement require the written authorization of the exchanger to disburse funds? It is important that the exchanger knows when and how the exchange funds are disbursed.
In addition, if the Qualified Intermediary is a publicly traded company (or a subsidiary of one) then federal laws commonly known as “Sarbanes-Oxley” require annual audits and a financial transparency that is not available for privately held entities. If the Qualified Intermediary is reluctant to provide any requested information, then the investor should be concerned. Security of funds is, and should be, an open book; if you are not comfortable, consider this a “red flag”! When selecting a Qualified Intermediary, many factors should be taken into account. But of all of these, the two most critical factors for evaluation are: safety and security of exchange funds; and competency of the staff. If properly trained in the legal requirements of the 1031 regulations, there is no reason that a successful deferral of taxes cannot occur. |