Exchange Place

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Peter McCrea had a client who wanted to sell a piece of undeveloped land in order to invest in a new hedge fund. It was obvious to both McCrea and his client that selling a $5milliion chunk of property with virtually no cost basis would result in a hefty tax bill. So McCrea—an advisor with, a subsidiary of LHO Group in New Canaan, Conn.—suggested instead that his client exchange the property for an income-earning interest in it that could be mortgaged after closing. McCrea's strategy allowed the client to liquidate and reinvest 100 percent of his equity without incurring taxes, retain a real estate allocation with the potential for appreciation, and invest in the hedge fund—thus achieving his main objective.

Key to the success of McCrea's approach was the switch of old property for new using a 1031 exchange, named for the section of the tax code that sanctions them. These exchanges have been around for decades but are still often overlooked by advisors, perhaps in part because 1031 exchanges must be brokered by "accommodators" intermediaries qualified according to the Internal Revenue Service—and involve other tax and legal experts, as well. Yet for property that has significantly appreciated but that your client no longer particularly needs, a 1031 exchange can be a tax-efficient exit strategy, say Phil Storms, an advisor with Westmont Cos. in Denver. The aim, he stresses, "is to find something that works better than what the client currently owns."

In a typical 1031 transaction, a property that's used in a trade or business—such as the building a doctor owns and practices in—or that is held for investment, like a rental home, is sold and replaced with a property or properties of like kind. From the point of view of the IRS, "like kind" just means the new property must be either raw land or used for business purposes. When this sale occurs, any gain rolls into the purchase of the new property or properties, assuming the new holdings are at least of equal or greater value, the difference—known as boot—is taxed as gain. Between the closings on the two properties, an accommodator—you find a professionally qualified on through the Federation of Exchange Accommodators (FEA) or through real estate agents or attorneys with 1031 experience—holds the proceeds in escrow. For instance, Judith Lau, president of Lau & Associates, a financial-planning firm in Wilmington, DE, has a client who owned a piece of farmland that was incurring costs when she needed more income. Lau helped arrange for the property to be exchanged for a small shopping mall occupied b rent-paying tenants through a third-party accommodator.

Storms find exchanges especially useful for clients nearing retirement. One of his clients had been renting out an inherited home in Delmar, CA, for years. As she planned for retirement, the $18,000 in annual rental income the house generated just wasn't adequate. Again, using an accommodator, Storms helped her exchange the $500,000 home for a building that leases space to a day-care center. Her $500,000 investment not generates $60,000 in annual income. "Had we sold and bought bonds," says Storms, "we would have earned only 8 percent on a principal greatly reduced by capital-gains taxes, which at the time [about 10 years ago] were 28 percent."

Storms also points out that 1031 exchanges can actually accelerate wealth accumulation for those willing to remain invested in real estate. Unlike sales involving other assets, which are held outside tax-advantaged retirement account and typically result in a principal-reducing taxable even, the tax deferral of 1031s keeps all invested moneys working And although the more property an investor holds and the more valuable it is, the more beneficial exchanging is, 1031 exchanges are effective for more than just your wealthiest clients.

Indeed, the IRS mad the exchanges even more user friendly when it acknowledged the acceptability of so-called reverse exchanges in a 1998 private-letter ruling to a utility company. Reverse exchanges allow property owners to buy a replacement property—which a qualified intermediary takes title to—before selling the old property. (The exchanges can apply to things other than real estate, too; see "Tit for Tat")

Gary Gorman, manager of Professional Exchange Accommodators in Englewood, CO, emphasizes the wealth-transfer and estate-planning opportunities afforded by 1031 exchanges. He offers this scenario: a family ranch or farm is exchanged by retiring parents for smaller real estate parcels, which are used by the offspring for business purposes. These can then be gifted to the children over time. Even if the parent retain ownership, the can still sell these smaller parcels over a period of tax years, giving the retired couple the ability to control when and how much gain they're realizing while at the same time reallocating their assets. Yet another alternative is converting rental properties into a personal residence. (see "Rent to Own")

It's the 1031 exchange's flexibility that draws advisers to them, despite the fact that planners themselves aren't part of the 1031 fee chain—only the accountants, attorneys, real estate agents, and accommodators realize an immediate income benefit from the transactions. "For us, [1031] exchanging is obviously not a primary part of our business or our investment strategy," says McCrea. But, he adds, "it serves our portfolios and our clients well" And this is the bottom line for McCrea.

It's the flexibility that draws advisors to 1031 exchanges

Also, like Lau and Storms, McCrea favors having real estate in client accounts for the diversification it offers. But they all stress that there needs to be a solid reason that a given piece of property appropriate for a particular client.

"When an adviser looks at a client's holdings, he needs to stop and ask, Oh are you doing this? What do you expect to gain from it?'" says Lau. "When a property is held for investment like an apartment complex, there is an opportunity to upgrade or diversify by accessing a 1031 exchange. But when the property serves a family purpose—like a beach house—exchanging isn't viable."

Once Lau establishes who property is being held, she asks herself whether the performance of the investment cam be improved. It can, the client makes a good candidate for a 1031 exchange, and it's time to find a good property. At this point, it helps to have a stable of referrals at hand, including a good real estate management team to refer the client to—someone who can find good properties for exchanges. "Coming up with the idea to exchange is simple," says Lay. Finding good replacement property—which allows the client to upgrade or diversify his holding or improve income—is not, she stresses.

She also recommends that clients engage attorneys who have 1031 expertise. "Familiarity with the issues and technicalities is not a common skill," says Lau. Qualified intermediaries even those with years of experience are not authorized to make tax determinations and their documents often relieve them of any responsibility if an exchange is disallowed. Their job is simply to accommodate the exchange: to hold the proceeds of sale—or title to the replacement property, if a reverse exchange is involved—in escrow until all the closing are completed. Although a good accommodator will have a strong grasp of the procedures and IRS rules that allow for these exchanges, the involvement of legal and tax experts to review documents and shepherd the exchange through its closings is seen as essential (For more on choosing an accommodator, see "The Buck Stops Here,")
The emphasis on expertise is universally shared by advisors who recommend 1031 exchanges to their clients. Why? The IRS will disallow improperly executed exchanges, meaning capital-gains taxes become due on the sold property. Most, often, the improper execution is a matter of poor timing says Keith Raker, a lawyer who handles 1031 exchanges at Arter & Hadden, a Cleveland law firm. Timing, as it relates to exchanges, is apparently almost everything.

First, the simple mistake of not getting organized early enough to have an opportunity to exchange is fairly common say Raker. Before a piece of property is put on the market—before the client even signs a sales agreement with a real estate agent—an accommodator needs to be engaged.

Problems can also crop up concerning the time taken between closing on the old property and identifying the new one. Most 1031 exchanges are delayed ones—the buyer and seller are not exchanging property directly with one another—and for the transaction to be considered valid, the person exchanging properties has to arrange for a qualified intermediary to handle the closing both on the old property and on the new. A 45-day window is allowed between closing on the old property or properties in a delayed exchange. The exchange of properties must be completed within 180 days to be valid, Take 46 days to shop around, or 181 days to close, and forget about deferring the tax on the gain. It is considered realized and due. Yet another mistiming that can undermine and exchange, according to Raker, has to do with when the tax returns are filed. If a client's tax return is due before the 180-day window closes, the client needs to extend his filing date or risk losing the deferral benefit.

Beyond bad timing, what else can go wrong? Unfortunately, as with any other large chunk of money, there's the risk that the funds could disappear—either through fraud or default. "Many accommodators offer fidelity bonds to insure against embezzlement,' says Tim Egan, executive director of the FEA in Sacramento. And most, he says, hold funds in bank CDs insured by the Federal Deposit Insurance Corporation.

Still this is not a federally regulated industry, adds David Kuns, an officer with Starker Services, a Los Gatos, CA, exchange accommodator, and a vice president with FEA. "Our industry is like any other where other people's money is involved. You need to know with whom you are dealing," Kuns says.

Yet for advisors, the biggest potential problem with 1031 exchanges isn't unscrupulous dealing but rather the threat of involving a client in a transaction unnecessarily. Raker stresses that swapping property merely to avoid taxes accomplishes nothing. "You need to be gaining some value—a fully depreciated property for one with development potential—or to trade up to a more expensive parcel," he says.

Lau agrees, "You need the right clients, sitting with the right property in the right portfolio. This is not something to do just because it sounds good—you need good reason as well," she says.

Indeed, sometime a portfolio is best served by simply paying the taxes, urges Kent Noard, an adviser with Sterling Wood Financial in San Jose, CA. Noard wards against becoming so enamored with tax avoidance that you lose sight of the investment potential—or lack thereof—of the new property. "Don't let [the] tax tail wag the dog," Noard says.

"The goal should be to find the best investment once a property is earmarked to sale, be it real estate or some other asset."

Whether it's a one-bedroom condo in Chicago rented out due to a job transfer to Los Angeles or vacant land in Arizona bought during a middle-aged fantasy about building a dream vacation home [1031 vacation home update: May 2007] —the opportunity exists to exchange leftover property into something more appropriate to a client's current investment need and market conditions. For the right person, exchanging versus outright selling can have very tangible results. Although knowing when to suggest them may garner only intangible results for an adviser, it's another means of adding value to your services.

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