Increasing your commissions by initiating 1031 exchanges with clients can be as easy as taking candy from a baby. So why don’t more agents suggest it to their clients? In short, most just don’t understand it well enough, experts agree.
Typically, when one of your clients sells investment property, he must report the 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 into another property of the same or greater value. The tax liabilities he stands to avoid can include a federal capital gains tax, state income tax as required in Illinois, city tax in Chicago and potential depreciation recapture taxes.
The 1031 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 clients from the federal government, in the amount the client would have paid in taxes, says Dale Bowling, regional sales manager for TIMCOR, a 1031 exchange company.
“With a modicum of knowledge, an agent has the ability to earn multiple commissions, rather than just one,” says Bowling.
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.
“It’s a really easy process once you understand it…and with computers and the Internet, much of it can be done online,” says broker Ron Bykowski with Century 21 Care Real Estate, owner of investment company Century Properties. “If an agent is familiar with the 1031 process, they have a duty to suggest or make clients aware that the 1031 exists.”
The first order of business is for you to identify a qualified intermediary to associate with 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.
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, says Scott Nathanson, senior VP and midwest manager for Nationwide Exchange Services. Keep in mind that intermediaries are not monitored like most financial companies; intermediaries are self-regulated and not overseen by the federal government.
“The scary part of [the self-regulation] is there are companies out there doing this work who aren’t really qualified intermediaries,” says Nathanson, who has practiced as a real estate attorney in Chicago for 15 years. His company conducts about 20 seminars each year to educate agents in Chicagoland about the ins and outs of 1031 exchange. He stresses that clients should know where their money is being held and not take chances with unproven intermediaries.
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.
“That 45-day window creates a highly motivated buyer,” says Bowling, noting however that all time limitations in the code are hard and fast. “They don’t have time to look at every property or talk to every agent. Agents don’t have to be experts, just know how it works and who to go to for the process.
“There are no extensions with the exception of natural disasters as part of a relief package Congress recently passed,” he continues. “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. Like every business deal, there are elements of risk and the code is fairly unrelenting on those.”
Many people use the 1031 process as a means to diversify their 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 Island; foreign properties do not qualify.
All of the above 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.
“The biggest issue the seller needs to remember is that all of the proceeds from the sale of the property have to be rolled over to the new property,” says real estate attorney Samuel Tamkin, who has dealt with these exchanges for clients for 20 years. “They think they’re about to sell a property, and they’re excited to be getting some cash, but the 1031 exchange requires all of the money be rolled over.”
Developers are excluded from using the exchange on inventory or they’d never pay taxes, says Bowling. In addition, 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.
Scott Maesel, a partner at Sussex and Reilly commercial real estate, says agents often come to him after a client has put one of their investment properties under contract and are in need of an instant property to identify for the exchange.
“A lot of times I get the frantic calls from people who have closed and have to identify a property within the 45-day limit,” says Maesel, a 15-year veteran of the real estate industry. His advantage is that his business partner, Sean Conlon, owns Near North Title Co. and serves as an easily accessible, qualified intermediary resource for Maesel’s 1031 transactions and tax issues. Conlon holds the money until it’s rolled into the new property.
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. C.A.
Regional Sales Manager
TIMCOR exchange coRP.
Century 21 Care Real Estate
Century 21 Sussex & Reilly
Senior Vice President
Nationwide Exchange Service
Attorney at Law