§1031 Exchange Intermediary

There is often confusion when it comes to defining what property qualifies for an exchange. Sometimes it is easier to describe situations that do not qualify. Real estate that is owned as “stock in trade or other property primarily for sale” cannot be exchanged. This type of property is deemed to be that of a dealer, which is held for sale to customers during the ordinary course of business. This type of sale is taxed as ordinary income.

SUBSTANTIATING THE INVESTMENT INTENT

The defining factor for qualification for a §1031 exchange is the taxpayer’s “intent” at the time of purchase. Was it the taxpayer’s intent to hold the property for investment? The burden of substantiating intent is that of the taxpayer’s. Here are some ways in which the taxpayer may establish investment intent:

• Advertising, promotional efforts, and other activities to solicit tenants for property can establish the intent to hold for investment.
• Conversely, advertising and promotional efforts aimed at soliciting buyers for the sale of the property would negate the intent to hold for investment.
• The listing of the property with brokers. Listing for rent establishes investment intent; listing for sale establishes intent to re-sell.
• The extent to which improvements, if any, were made to the property. Improvements aimed at securing a tenant help establish investment intent; other improvements could be argued to establish intent to re-sell. Granted, there is a lot of gray area here.
• The frequency, number, and continuity of sales. A particular taxpayer who buys and re-sells frequently might have difficulty establishing intent to hold for investment.
• The ordinary course of business of the taxpayer. Is the taxpayer typically a landlord or a dealer?

CAN A “DEALER” PERFORM AN EXCHANGE?

Simply because a taxpayer re-sells property regularly does not automatically disqualify that taxpayer from ever benefiting from an exchange. It is good practice for a taxpayer to separate his or her activities between entities. For instance, he or she may establish a Sub-S corporation for dealer activities and an LLC for longer-term hold properties. In this way, intent is easier to establish for taxpayers involved in both worlds.

REVIEW WITH LEGAL AND/OR TAX ADVISORS

As with any aspect of exchanging, we strongly advise all taxpayers, and particularly dealers, to discuss potential exchanges with their trusted tax advisor and/or attorney before moving forward with an exchange. This brief discussion only scratches the surface of the subject covered.

Ken Tharp

Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.

INTEGRITY.  PRECISION.  SECURITY.

One of the most common questions I get asked is something along the lines of "Can you just explain to me how an exchange actually works?" Just as no two real estate sales are identical, no two exchanges are the same. What this blog attempts to do, however, is present the steps of a typical delayed exchange transaction in a simplified format. A basic exchange is actually a fairly simple process, but many, many considerations must be made in order to ensure that the exchange is done properly to qualify for tax deferral.

THE FIRST STEP

The first step of a §1031 exchange is generally the recognition that an exchange may be in order. An investor, for whatever reason, wishes to sell a property that would qualify for tax deferral through the use of §1031 of the Internal Revenue Code. He contacts a Qualified Intermediary (“QI”) such as Iowa Equity Exchange and an exchange agreement is drawn up and signed by the intermediary and the investor. Now everyone waits until a buyer is found for the property that the investor is selling. (Alternatively, the investor may already have a buyer and the exchange agreement is created after the property is under contract. The critical factor is that the sale must not have closed prior to signing the exchange agreement.)

THE SECOND STEP

When the property sells, the next step is getting it closed. The QI will have some paperwork for the buyer to sign, usually no more than one or two documents, that notify the buyer of the exchange and request his acknowledgment. As the closing approaches, the QI provides a set of documents and instructions to the closing agent for the transaction. Included is the information on what the closer is to do with the proceeds of the transaction, which in a typical case will be wired directly into a newly-established bank account to be held in trust by the QI during the exchange period.

From the date of closing, the exchanger has a period of forty-five (45) calendar days to properly identify potential replacement properties. To identify replacement properties requires the exchanger to provide a list of those properties to the QI under the rules of §1031, which are made clear to the exchanger by the QI. In many cases, the exchanger has been looking for potential replacement properties since his property was first put up for sale, or even before. Because the 45 day period often seems to pass rather quickly, it is a good idea for an exchanger to have an active plan of how to locate potential replacement properties. If the identification process fails, the exchange is over and the tax obligation is not deferred, so this step is critical.

Keep in mind that the replacement property need not be under contract during the 45 days, merely properly identified. The replacement property can be placed under contract prior to the closing of the relinquished property, during the 45-day identification period, or after the identification period has ended (as long as the property is listed on the identification letter). 

THE THIRD STEP

At some point in a successful exchange, the replacement property is placed under contract. Regardless of the point at which the property is placed under contract, the exchanger has a total of one hundred eighty (180) calendar days from the date of closing of the relinquished property to close on the replacement property. As with the sale of the relinquished property, the QI prepares a couple of notification/acknowledgement documents for the seller of the replacement property to sign. Time passes and the closing date of the replacement property approaches. The QI provides documents and instructions to the closing agent for the replacement property. When the closing occurs, the proceeds that the QI has held in trust are wired to the closing agent. The closing occurs and the exchanger has successfully completed his exchange for the new property.

THE WRAP UP

After the replacement property has closed, the QI will compile all of the documents used throughout the exchange process. A set of these documents is provided to the exchanger, and if desired, can be provided to the exchanger’s legal and tax advisers as well. At that point, the exchange is concluded.

SOME ADDITIONAL COMMENTS

The scenario described above is extremely simplified. There are many other intermediate steps necessary to accomplish a successful exchange. The QI often consults with the exchanger’s other advisers, such as his attorney and his tax adviser, to determine the need for an exchange and to keep the exchange on solid footing.

REVIEW WITH LEGAL AND/OR TAX ADVISORS

It is important that all taxpayers review their transaction with their attorney and/or accountant before proceeding with an exchange. There are many issues not covered in this short discussion which may affect the ability of a taxpayer to successfully complete an exchange transaction.

Ken Tharp

Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.

INTEGRITY.  PRECISION.  SECURITY.

Until this point, my blogs have consisted of setting out the benefits of Section 1031 exchanges and the mechanics of the actual exchange. Today I want to address a critical issue regarding the future of tax-deferred exchanges.

SECTION 12504

Many of you do not follow the industry of agriculture very much; I’ll admit it, I don’t either. I live in metropolitan Des Moines, Iowa, which to those of you on the coasts may conjure up images of corn fields and hogs. Those of you in the Midwest, however, know the reality. Yes, we have many farms in Iowa, and yes, they are a vital part of our economy. But the last time I was actually on a farm, was, well, I have no idea. Any time I get on one of the Interstates, I drive past them, but farms are not an integral part of my life. I do deal with them in my business, because farm land is a significant asset and is often a part of one side or the other of an exchange.

So why am I writing about the Farm Bill? Because it contains a little section that could have a major impact on the future of Section 1031 exchanges for all investors, business owners, Realtors®, and anyone involved in the field of real estate. In my blogs, I haven’t yet discussed the concept of “like-kind” in any detail, so I need to address it here at least briefly. To qualify as a proper tax-deferred exchange, real estate must be exchanged for “like-kind” real estate. However, the only real restriction is that the relinquished property (the one the taxpayer is selling) and the replacement property (the one the taxpayer is purchasing) must both be either used in the pursuit of a business or trade OR held for investment. That’s pretty broad, don’t you agree? Raw land can be exchanged for an apartment building. An office building can be exchanged for three single-family rental homes. The only true restriction is that real estate that is not held for investment or used in the pursuit of a business or trade cannot be part of an exchange (e.g., a property purchased with the intent of reselling quickly at a profit, a personal residence, etc.). Section 12504 of the Farm Bill that is currently being considered in the Senate of the United States seeks to change that as it relates to agricultural real property.

Section 12504 would amend the like-kind standard that has been in place for many years to provide that “unimproved agricultural real property” is not like-kind to “improved real property.” In this context, “unimproved agricultural real property” is agricultural land that is enrolled in certain farm subsidy programs, unless the agricultural land is permanently retired from the farm subsidy programs prior to the date of the exchange transaction.

The effect of this would be to prevent taxpayers from exchanging out of, or into, subsidized agricultural land. A farmer who currently owns such land would not be able to exchange into any improved real property, such as commercial, residential, or tenant-in-common (TIC) properties. Owners of improved real property could not exchange into subsidized agricultural land. (This, by the way, appears to be the intended target of this section. Apparently, Congress either believes that too much farm ground is being sold to developers, or that if sales do take place, the Treasury deserves a piece of the action. Regardless of where you stand on those issues, this proposal goes far beyond either of those matters.)

The current theory within the exchange industry on the impact of this proposal is that it will cause farmers who own subsidized land to either hold onto their properties, or to “bite the bullet,” sell without the benefit of exchange transactions, and pay the taxes. It is believed that this will have a significant impact on the exchange industry, the real estate industry, and those who work with TIC properties.

But perhaps most importantly, the proposal creates a precedent that could result in the gradual diminution of Section 1031.

Now, let’s look at this another way. Remember when you played pretend games when you were a child? Let’s play one. Pretend you are a farmer. You are nearing retirement after working a lifetime on your farm that’s been in the family for generations. While you were running your farm (remember, farms are businesses, too), the government offered you a subsidy program. You weren’t wild about the idea, because you were proud and didn’t like the idea of accepting something from the government. Still, you were running a business, so you ultimately made a business decision and accepted the subsidy. Today, for whatever reason (no offspring willing to take on the responsibility, development has reached your doorstep, etc.), you recognize the need to sell your property. Because you inherited the farm forty years ago, you face a monstrous capital gain. But the government has, for many, many years, recognized the validity of the tax-deferred exchange, allowing a taxpayer to move the equity from one investment (the farm) to a new investment without the recognition of a taxable gain, if done properly. You decide that the time has come to sell and move your investment into something that requires a lot less management than your farm. And what does the government do? They tell you that, because you accepted the subsidy that they practically forced you to accept, you can no longer shift that investment into what they now have decided is not “like-kind” property. As I searched for an analogy to wrap this up, the one that comes to mind is Lucy telling Charlie Brown that she will hold the football for him to kick, assuring him that she won’t pull it away, and then pulling it away at the last instant to have Charlie Brown end up flat on his back.

What can you do about it? There seems to be a fair chance that President Bush will veto this bill if it reaches his desk, and the Senate does not appear to have the votes to override his veto. So maybe it will be okay. But will it? If Congress has it in their heads that this is a good idea, it won’t stop here. It’s up to us to stop it. If you believe that this is important, write to your Senators and your Congressmen and tell them to pull this section from the Farm Bill. Preserving a taxpayer’s investment and the ability to shift that investment into the vehicle of his choice without tax consequences is as vital to the real estate industry as it is to the taxpayer himself.

Ken Tharp

Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.

INTEGRITY.  PRECISION.  SECURITY.

“HELD FOR INVESTMENT”—WHAT'S THAT?

The actual wording of Internal Revenue Code §1031 says that in order to qualify for tax-deferred treatment, the property owner must sell property that has been “held for productive use in a trade or business or for investment” (emphasis added) and purchase property of like-kind. Often, potential exchangers want to know how long they have to own property to establish that it has been “held for investment.” Unfortunately (or perhaps fortunately), neither the IRS nor the Regulations gives us a complete answer on that subject. If some specific time frame were established, it would certainly be an easier question to answer. On the other hand, if there were a specific time frame prescribed, the exchanger would have no possibility of building a case for the disposition of property held for less than the prescribed amount of time. So, although not setting out an exact period of ownership required creates some uncertainty, if it can be established that the property was indeed held for investment, the current state of no guidance actually provides greater latitude to the potential exchanger.

ESTABLISHING INTENT

So what's the investor supposed to do? If the investor believes, for whatever reason, that an opportunity to sell the property early in the holding period may arise, he would be wise to take some actions to establish that his intent upon purchase was to hold the property, not sell it. Want an example? Let’s say the investor purchased a nice single-family home in West Des Moines, Iowa (or wherever), with the intention of keeping it as a rental property. He rents the home to a family moving from Cedar Rapids. They live there for four months and decide that they love the home and ask about buying it. Can you imagine that happening?

So at the outset, with the intention of holding the property for investment, the investor takes appropriate actions: He holds the property out for rent to the open market. He runs ads in the local paper. He places the property on Craigslist and other online services. He distributes flyers to local places of business. He maintains the property in a manner consistent with preserving his investment. He essentially treats the property as the investment that it is. By keeping copies of ads, records of actions taken, and the like, the intent to hold the property as an investment can be verified if questioned in the future. And if an opportunity to sell that he cannot pass up happens to arise after a short period of ownership, he can sell with the knowledge that he has made every attempt to establish his intention to hold the property as an investment. There is no guarantee that the IRS agent on the other side of the table will agree with him, but he stands an infinitely greater chance of success with some documentation on his side than without.

WHAT IF INTENT IS DIFFICULT TO ESTABLISH?

Now let's assume that our investor friend did not keep copies of ads and records of activities relating to preserving the investment intent for the property. (Arguably, in this day and age, this discussion may be moot, what with the availability of archived newspapers online, handheld appointment schedulers and record keeping, etc., but let's assume the worst. Maybe he moved from Des Moines and lost all of the records in the move…) In the exchange industry, it is pretty widely accepted that ownership for a period of two years should qualify for tax-deferred treatment. A one year period of ownership is less accepted, but still fairly widely believed to be adequate. A somewhat less widely accepted notion is that a holding period encompassing two tax years may satisfy the IRS, given other factors that also support investment intent. Theoretically, that could involve an extremely short period of ownership (Dec. 27 to Jan. 4, for instance, for the calendar year taxpayer). However, I would not advise trying this unless the investor believes strongly that he would prevail and is willing to put up a vigorous defense, because it would almost certainly be challenged. 

The key factor, if you haven't picked up on it already, is the INTENT of the investor at the time of purchasing the property. If the intent was to hold the property for investment, and if it can be adequately substantiated, let's get the exchange paperwork started.

Ken Tharp

Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.

INTEGRITY.  PRECISION.  SECURITY.

It's clear that Section 1031 tax-deferred exchanges provide real estate agents a tremendous opportunity to increase commissions. But more importantly, you are serving your client's best interest when you are able to recognize an opportunity for a tax-deferred exchange. Think about it. What's better for your client? Paying taxes, or being able to put more money into a property by deferring those taxes? At Iowa Equity Exchange, we say, "Help your clients grow their investments, not their tax bills!" We also say, "Help yourself by helping your clients."

Here are a few questions that are commonly asked by real estate agents:

Q: WHO SHOULD I CONTACT TO SET UP AN EXCHANGE?

A: As you might expect, we strongly suggest that you call the office of Iowa Equity Exchange in West Des Moines, Iowa, at 515-224-5259! We can act as the intermediary for your exchange anywhere in the United States.

Q: WHEN SHOULD I CONTACT IOWA EQUITY EXCHANGE?

A: Contact us as soon as you recognize that your transaction might be a candidate for an exchange. We will be happy to consult with you and your client to determine whether the client's situation warrants an exchange, and we'll be straight with you if it doesn't. For a complicated transaction, consultation may involve the client's legal and/or tax adviser(s). We are not attorneys or accountants, and as an intermediary we are specifically restricted from providing legal or tax advice. We always suggest that the client discuss his or her plans with his trusted advisers to make the final determination regarding an exchange. Our fee only applies if the transaction closes, similar to your real estate commission, so take advantage of our consultation offer. The bottom line answer to the question is to involve us as early in the transaction as possible.

Q: WHAT CONTRACT LANGUAGE SHOULD BE ADDED TO THE PURCHASE AGREEMENT?

A: You can add the language below to your Purchase Agreement, which will notify the buyer of the seller's intention to perform a tax-deferred exchange. It also makes it clear that the other party will incur no additional cost or liability as a result of his or her cooperation. A clause such as this is not required by for a tax-deferred exchange, but it is usually better to keep all parties informed from the outset.

“It is the intention of the Seller to transfer the above-listed property pursuant to Internal Revenue Code Section 1031, which sets forth the requirements for tax-deferred real estate exchanges. Seller’s rights and obligations under this and future agreements will be assigned to Iowa Equity Exchange, Qualified Intermediary, for the purpose of completing an exchange. Buyer of the above-listed property agrees to cooperate with Seller and Iowa Equity Exchange in a manner necessary to enable Seller to complete said exchange. Such cooperation shall be at no additional cost or liability to Buyer.”

When your client is ready to purchase his or her replacement property (the new property), the same language can be added to that Purchase Agreement, substituting "Buyer" for "Seller" and "Seller" for "Buyer." In this case, your client may wish to add the clause after the initial terms of the deal have been established. Some buyers feel that by disclosing the fact that the transaction is part of a Section 1031 exchange, it may provide the seller reason to negotiate more firmly, thinking that your buyer may be in a position of needing to buy the property in order to complete his exchange.

Q: WHAT TYPES OF SITUATIONS ARE SUITABLE FOR A §1031 EXCHANGE?

A: Every time you list any property that may have been “held for investment” (e.g., rental house, second or vacation home [there are specific restrictions on this type of property, however], duplex, office building, commercial building, apartment building, raw land, etc.), or has been used in the pursuit of a business or a trade (e.g., auto body shop, office condo, etc.) recommend that your client talk to his or her legal and/or tax advisers about the benefits of a §1031 exchange. You can also call us for a consultation, with or without your client. Call us if you'd like to run the situation past us to see whether it's a possible candidate. Too often, your client will think, "Well, I'll just pay the 15% federal capital gain tax and not worry about it," without thinking about the cost of state capital gain tax and depreciation recapture. (See my blog below titled "Tax-Deferred Exchange 101" for details about the three-pronged whammy that is levied against the investor who does not use Section 1031 when s/he sells property.)

As a licensed professional, a real estate agent cannot afford to say, “I don’t know about exchanges because I specialize in residential.” Remember, you are working in your client's best interest by raising the possibility of an exchange.

Q: CAN A §1031 TAX-DEFERRED EXCHANGE BE SET UP AT THE LAST MINUTE?

A: Yes. As long as the transaction has not closed, Iowa Equity Exchange can successfully convert a sale into an exchange. Documents can be prepared and delivered to the title company within a short period of time if necessary. Obviously, it's to everyone's benefit to have more time to consider the situation, but we can act on short notice if needed. However, once the closing has occurred, even if the seller has not deposited the proceeds check, it is too late...

In closing, remember this - it will not hurt anything to investigate the possibility of structuring an exchange. And think about this - how will your client feel about you if s/he does not know about exchanging, but finds out after the sale closes? As a real estate professional, you owe it to your clients to recognize the viability of exchanging. Conversely, you can be a hero and create a client for life if you bring it up and s/he happens to be hearing about it for the first time, or hadn't thought of it relative to this particular transaction.

Good exchanging... let me know if we can help.

Ken Tharp

Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.

INTEGRITY.  PRECISION.  SECURITY.

WHAT IS SECTION 1031?

Section 1031 of the Internal Revenue Code (IRC) allows an owner of investment property to defer the payment of federal and state capital gain taxes by purchasing “like-kind” property following the rules and regulations of the IRC. Capital gain taxes are typically 15% of the gain, plus 25% recapture of depreciation taken, plus applicable state taxes, which in Iowa are presently 8.98%. (Adding just the federal capital gain tax to the Iowa capital gain tax results in taxes of 24% of the investor's gain. Depreciation recapture can add another significant amount onto the 24%, often pushing the total tax liability well above 30% of the gain.) Section 1031 allows investors to use all of the sale proceeds to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management obligations, or consolidate holdings.

WHAT IS “LIKE-KIND” PROPERTY?

The Internal Revenue Code Section 1031 states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” “Like-kind” property can be interpreted broadly as far as real estate goes, provided that the property purchased is held for investment, such as:

• Single-family rental
• Duplex
• Apartment building
• Commercial property
• Raw land

For example, raw land in Iowa can be exchanged for a single family rental in Des Moines, or apartments in Omaha or a commercial building in Missouri.  Four single-family rental homes can be exchanged for one apartment building; one office building can be exchanged for two pieces of raw land. Properties can be exchanged anywhere within the United States.

DOES AN EXCHANGE NEED TO BE SIMULTANEOUS?

The old notion of a two-party swap rarely occurs. The vast majority of exchanges are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of the replacement property. The taxpayer must identify the potential replacement property (or properties) within 45 calendar days of closing on the relinquished property.

WHEN IS A SECTION 1031 EXCHANGE APPLICABLE?

It is applicable whenever an individual or an entity sells any property that has been held for investment or for use in business and contemplates purchasing another “like-kind” property within 180 calendar days following the closing of the relinquished property.

[Note: Iowa Equity Exchange cannot give tax and/or legal advice. Every taxpayer should review specific transactions and potential tax consequences with his or her personal tax and/or legal advisor.]

For more information about exchanges, please visit our web site at www.iowaequityexchange.com, or just give us a call.  

Ken Tharp

Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.

INTEGRITY.  PRECISION.  SECURITY.

Let's talk about what a Qualified Intermediary does, and even what a Qualified Intermediary is. The Internal Revenue Code establishes the use of a Qualified Intermediary as a "Safe Harbor" for the performance of a tax-deferred exchange under the rules and regulations of Section 1031. What's a Safe Harbor? Essentially, it means that if an individual conducts his or her exchange within certain boundaries, the exchange cannot be challenged; it is within a safe harbor in that case.

SO WHAT'S A QUALIFIED INTERMEDIARY? 

Certain entities can function as a Qualified Intermediary. It's easier to talk about who cannot be a QI than who can be. Your attorney cannot function as your QI if he or she has represented you within the previous two years; nor can your accountant. Same for your real estate agent. Anyone who has represented you in a professional capacity within the previous two years cannot function as your Qualified Intermediary in a Section 1031 tax-deferred exchange. Those people are disqualified; you need someone who is a disinterested third-party. You need a Qualified Intermediary.

What does a Qualified Intermediary actually do? First of all, a QI enters into a written agreement (the "Exchange Agreement") with the party who wishes to exchange property. Within that agreement, the parties agree that the QI will:

• Acquire the relinquished property (the property the exchanger wants to sell) from the exchanger;
• Transfer the relinquished property to the new Buyer;
• Hold the proceeds of the sale of the relinquished property in trust for the exchanger;
• Acquire the replacement property (the property the exchanger wishes to buy); and
• Transfer the replacement property to the exchanger.

The Exchange Agreement must expressly limit the exchanger's rights to receive, pledge, borrow, or otherwise obtain benefits of the funds held by the Qualified Intermediary. This is because the I.R.C. specifically states that the exchanger cannot have "actual or constructive receipt" of the proceeds of the sale of the relinquished property. This goes back to the safe harbor I mentioned earlier. Should the exchanger have control of the funds (whether actual control or constructive control), the exchange would be disallowed. For example, if the QI is the exchanger's accountant, it is the determination of the I.R.C. that constitutes constructive receipt of the funds. 

Another important function of the QI is to assure the use and proper execution of the required documentation for an exchange. Having I's dotted and T's crossed is one of the more critical responsibilities of the Qualified Intermediary.

Time monitoring is another crucial task of the QI. There are dates before which certain things must be done to stay within the safe harbor afforded by the I.R.C. It is the responsibility of the QI to transmit that information to the exchanger and then to monitor the exchanger's progress as those dates approach. 

In addition to the above list and descriptions of the QI's duties, the QI also does the following:

• Coordinates with each exchanger's attorney and/or tax adviser. Forward exchange documents as necessary to those advisers so that I.R.C. Section 1031 rules and regulations are clearly understood.
  
• Prepares the exchange documents needed for the transaction - the Exchange Agreement, the Assignment Agreement(s), the Notice of Assignment(s), the Qualified Exchange Account form, Instructions to the closing agents for the transaction(s), etc.
• Oversees each closing to confirm that procedures for a successful exchange are followed.
• Facilitates the sale of both the relinquished property and the purchase of the replacement property.
• Keeps and secures the proceeds of the sale of the relinquished property on behalf of the exchanger until funds are needed to purchase the replacement property. Some QI's do not pay interest on funds while held in trust; Iowa Equity Exchange pays an outstanding money market rate to the exchanger for each day that the funds are in our possession.
• Provides guidance, information, and critical timelines throughout the entire exchange process.
  

That gives you an idea of what a Qualified Intermediary does. The QI does not practice law or accounting, but must have a thorough knowledge of each as it applies to I.R.C. Section 1031 exchanges. 

For more information about exchanges, please visit our web site at www.iowaequityexchange.com.  

Ken Tharp

Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.

INTEGRITY.  PRECISION.  SECURITY.

I thought for my first blog post I would provide an overview of what Section 1031 tax-deferred exchanges are all about. This is going to be geared toward those folks who have never heard of tax-deferred exchanging, or perhaps they've heard of them but don't know much at all about them. Let's start out with some background:

EXCHANGES ARE A POWERFUL TAX STRATEGY

Tax-deferred exchanges have been a part of the tax code since 1921 and are one of the last significant tax advantages remaining for real estate investors.

One of the key advantages of a §1031 exchange is the ability to dispose of a property without incurring a capital gain tax liability, thereby allowing the earning power of the deferred taxes to work for the benefit of the investor (called an “Exchanger”) instead of going to the government. The reason the tax deferral is allowed is based on the theory that the investment itself does not actually change; merely the form of the investment changes. I like to use the analogy of an IRA rollover. If you do it properly, you can roll over the proceeds of an IRA with one company to an account with a new company. Part of that process is that you cannot receive the funds yourself; they have to go from the old company to the new one. Tax-deferred exchanging is similar in that you cannot receive, or have control over, the proceeds of the sale of the property you are exchanging out of.

So, what's the point? The point is that a lot more of the seller's proceeds can go toward the purchase price of the new property. In future blogs, I'll give you a more detailed example, but just imagine this for now - a seller sells a property for $100,000 that has a mortgage balance of $50,000. After paying off the mortgage and the costs to sell the property, there is $40,000 remaining. If Mr. Seller takes that money and invests it in a new property, he will be left with nothing to pay his capital gain taxes (federal and state), plus the cost of depreciation recapture.

Let's break this down. First, let's deal with depreciation recapture. Depreciation is a write-off that is allowed for investment properties whereby the investor can depreciate the "improvement" portion of his investment (i.e., the building). It does not apply to land. Depreciation is great during the time the investment is owned because it offsets income from the property (and other income as well), but when the property is sold, recapture can be a bear. All of the depreciation taken during the course of ownership must be "recaptured" on the tax return and repaid at a rate of 25%. How much was this investor's depreciation recapture? It depends upon how long he owned the property. For our example, we're going to assume that this investor paid $60,000 for this property. If it appreciated from $60,000 to $100,000 and it's in Iowa, chances are good that he's owned it for a while. My HP12c tells me that, at 4% annual appreciation, it would take 14 years for a property to rise from $60,000 to $100,000. At today's depreciation rates, this investor would have something along the lines of $20,000 of depreciation to recapture. Twenty-five percent of that amount is $5,000.

Now we need to determine the amount subject to capital gain tax. Federal capital gains are currently taxed at 15% with few exceptions. How much is the seller's gain? Paid $60,000, sold for $100,000, there's $20,000 of depreciation being recaptured; his remaining gain would be $20,000. 15% of $20,000 is $3,000 that he'd have to have available come April 15.

Moving on to state capital gain rates. Of course, different states have different rates. Since I do a majority of Iowa tax-deferred exchanges, I'm going to use Iowa's rate, which is 8.98% pretty much across the board. We'll round to 9%. The 9% applies to the entire $40,000 in gain, so that's another $3,600 to taxes.

So let's total it up. Federal capital gain tax = $3,000; state capital gain tax = $3,600; depreciation recapture = $5,000, for a grand total of $11,600. Bear with me and let me round that up to $12,000 to see the effect.

If the investor held back $12,000 from his $40,000 to pay taxes, he could only reinvest $28,000. If he used that as a 20% down payment on a new property, he could buy property worth $140,000. On the other hand, if he used the provisions of Internal Revenue Code Section 1031, he could reinvest the entire $40,000 because all of the taxes and recapture that we just calculated would be deferred. Using $40,000 as a 20% down payment, he could buy property worth $200,000. Now, if you are an investor reading this, would you rather have a $200,000 property with $40,000 in equity, or a $140,000 with $28,000 in equity? And if you are a real estate agent reading this, would you rather sell a $140,000 property to this investor, or a $200,000 property? The answers to both of those questions are a couple of the reasons that Section 1031 tax-deferred exchanges make so much sense.

Hope this wasn't too dry. Exchanges can often be very simple, but they can sometimes be extremely complex. Make sure that you are working with someone who knows how to handle the exchange for you. We, of course, recommend Iowa Equity Exchange! We can perform exchanges anywhere in the United States, not just Iowa. If you have any questions about exchanging, please check out our web site or give us a call.

Ken Tharp

Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.

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