SIMPLIFYING EXCHANGES THROUGH THE USE OF AN INTERMEDIARY
In an era of increasingly complex real estate transactions, one of the most complex, 1031 Exchanges, has become far more easily managed. Many real estate investors are put off by the "supposed" complexity of exchanging. Even with the issuance by the I.R.S. in May 1990 of the new proposed regulations, real estate and tax advisors without extensive experience in this particular area tend to shy away due to the intricacies involved. A qualified and reputable intermediary can ease concerns, make these sophisticated transactions run smoothly, and help save tax dollars.
The availability of a tax deferred exchange remains one of the largest motivations to invest in real estate. In fact, after federal tax changes in recent years, tax deferred exchanges may be the only true tax shelter left. Exchanges, once only the province of the wealthy, sophisticated investor, are now an important tax planning tool for all real estate investors.
Originally created so the IRS could avoid the administrative problems of dealing with small asset "swaps", IRC Section 1031 has remained in the Code in recent years as an incentive to attract real estate investment. Investors are encouraged to acquire real estate that can be disposed of at a future date with a "reinvestment" of the proceeds into other real property without burdensome tax consequences. The term "tax free" exchange is often used, but since the tax consequences of such transactions are merely postponed and not avoided, the proper term is "tax deferred".
Some fundamental rules must be observed in real estate exchanges. The failure to understand these basic requirements and advise clients accordingly may expose real estate professionals to the risk of malpractice claims.
1. The right to Exchange must be reserved in the initial sales contract.
2. Structure of the transaction must provide for interdependence between the disposition and acquisition of properties. There must actually be an "exchange".
3. Both the relinquished property and the replacement property must be qualifying like-kind real property. Put into practical terms, this requirement merely excludes dealer property, foreign property and personal residences.
4. In order to avoid recognizing any gain, all cash proceeds must be utilized to acquire the replacement property, and the debt the exchangor is relieved of must be equaled or exceeded by the debt on the replacement property.
A simple, two-party exchange rarely occurs. It is unlikely that the owner of the replacement property will wish to acquire the relinquished property at the same time. Usually at least three parties are involved:
EXCHANGOR = You (the taxpayer).
BUYER = The buyer of the relinquished property.
SELLER = The seller of the replacement property.
Ordinary exchange transactions are often structured in either of the following ways:
Step 1.EXCHANGOR and SELLER "Exchange" properties.
Step 2.SELLER sells the relinquished property to BUYER.
Step 1. BUYER purchases the replacement property.
Step 2. EXCHANGOR and BUYER "Exchange" properties.
In ordinary exchanges, using either method, both steps 1 and 2 will occur simultaneously. EXCHANGOR has only exchanged and has not participated in a sale closing or a purchase closing. What can complicate the transaction is that the BUYER or SELLER are often unwilling to be involved in the "exchange" process. In both methods, either BUYER or SELLER (willing or NOT) must, of necessity, be involved in an additional transaction. This problem can be eliminated entirely by using an INTERMEDIARY. The same exchange transaction utilizing an intermediary would be structured as follows:
Step 1. EXCHANGOR conveys the relinquished property to INTERMEDIARY (as part of the exchange).
Step 2. INTERMEDIARY sells the relinquished property to BUYER and receives $$$.
Step 3. INTERMEDIARY purchases the replacement property from SELLER with $$$ received from BUYER.
Step 4. INTERMEDIARY conveys the replacement property to EXCHANGOR to complete the exchange.
In an ordinary exchange, all four steps will occur simultaneously. BUYER is only involved in the purchase (step 2), and SELLER is only involved in the sale (step 3). Neither are involved in any extra steps so should have no hesitation in agreeing to allow the transaction to be structured as a real estate exchange. EXCHANGOR an the other hand is only involved in steps 1 and 4 (the exchange) and has neither bought or sold property.
On many occasions, BUYER will want to acquire the relinquished property before EXCHANGOR can acquire the replacement property, or before EXCHANGOR has even locate the replacement property. In this case, the transaction is handled over a period of time and is called a "delayed exchange". In addition to meeting all requirements for a concurrent exchange, a delayed exchange must meet the following additional requirements:
1. The replacement property must be properly identified within 45 days from the date of the first sale.
2. The replacement property must be acquired by the earlier of:
(a) 180 days after the first closing OR
(b) The due date of EXCHANGOR'S tax return (with valid extensions).
3. Exchangor may not have actual or constructive receipt of the funds held during the EXCHANGE.
In delayed exchanges, SELLER cannot be the cooperating third party (as described in METHOD 1) since he is either not known at the time, or is not ready to close. And though BUYER might be available, the following must be taken into account before utilizing BUYER as described in Method 2:
1. EXCHANGOR must transfer the relinquished property to BUYER before BUYER can acquire the replacement property.
2. At the time BUYER is required to complete the transaction (acquire the replacement property), BUYER has already had possession of the relinquished property for some time. If BUYER has any complaints about that property (ie. the roof leaks, etc.) he may utilize his completion of the exchange as a bargaining tool. BUYER may refuse to complete the transaction until EXCHANGOR resolves all problems with the relinquished property.
3. There can be no security for the funds BUYER will utilize for his performance, since most security arrangements that a BUYER can provide for such funds will jeopardize the exchange.
4. BUYER might misuse the funds, or his creditors may attach them.
5. BUYER may become injured to the point of incapacity, die, be involved in a divorce, or leave the country, all of which may make timely closing of the exchange impossible. Delays alone may destroy an exchange.
6. Any tax or judgment lien against BUYER would attach to the title to the replacement property when acquired by BUYER and would need to be cleared prior to the conveyance of that property to EXCHANGOR.
All things considered, BUYER may possibly be the worst choice of parties to assist EXCHANGOR in achieving a tax deferred exchange. Bringing an INTERMEDIARY into the transaction simplifies matters significantly. EXCHANGOR can convey the relinquished property to INTERMEDIARY and INTERMEDIARY can sell that property to BUYER whenever BUYER desires to acquire title. INTERMEDIARY will then hold the funds derived from the sale until some future date when EXCHANGOR has located the replacement property and is ready to close that purchase. INTERMEDIARY then acquires the replacement property and immediately and concurrently, conveys that property to EXCHANGOR. As soon as BUYER's purchase closes, he is no longer involved in the transaction and cannot in any fashion interfere with the completion of the exchange. When the replacement property is acquired, SELLER will merely convey title to that property to INTERMEDIARY, and will have no additional involvement in the exchange.
It is important to know that any direct security interest on the funds held by INTERMEDIARY will jeopardize an exchange. The key point here is that EXCHANGOR cannot have any control over the funds at all. The best (and possibly only) security that can be utilized in a delayed exchange is a third party security arrangement like a stand-by letter of credit.
Another critical issue is the relationship between EXCHANGOR and INTERMEDIARY. If INTERMEDIARY is the attorney, title company representative, or broker for EXCHANGOR, or if INTERMEDIARY is closely related to EXCHANGOR in any fashion, INTERMEDIARY will be deemed to be the agent of EXCHANGOR. EXCHANGOR cannot have a valid tax deferred exchange with his own agent! It is imperative that INTERMEDIARY be an independent principal, acting in its own behalf, and not deemed to be an agent of EXCHANGOR.
While exchanges will continue to require careful planning to insure compliance with I.R.S. requirements, the use of a well qualified, experienced intermediary makes the process far more secure and manageable.
AMHERST EXCHANGE CORPORATION
130 EAST CARRILLO STREET
SANTA BARBARA CA 93101
805 962 6262. FAX:805 962 3362