Deciding up a 1031 exchange, setting it up and managing it effectively is no trivial matter; nor, typically are the stakes that hang in the balance of successful exchange transactions. One key to ensuring an exchange is ultimately successful happens in the selection of the exchange coordinator. These coordinators, or Qualified Intermediaries, as they are called, work with property owners to determine the type of exchange that is best in any given situation, then, to varying degrees, manage the steps of the exchanges to ensure financial goals are being met. Not all coordinators are alike, and it is worth taking the time to evaluate the backgrounds of any QI that you consider working with on the exchange.
Basics of 1031 exchanges
The 1031 exchange is a provision in the tax code that allows property owners to avoid capital gains tax on the proceeds from the sale of that property by exchanging it with property that is of like-kind. They are used by businesses and individuals alike, but the definition of “like-kind,” varies depending on whether it the property is owned by a company or a person.
There are several different forms of exchange. Exchanges can be done simultaneously, in which case the properties are exchanged at the same time. They can also be set up so that the sale of the existing property precedes the purchase of the new property.
How to select the right coordinator
First, these transactions require the services of a QI in order to be recognized by the IRS as qualifying for the tax benefit. So, bear in mind that 1031 exchange is not an occasion for “do it yourself.” Second, it is helpful to know that there is an industry organization for QIs, call The Federation of Exchange Coordinators (FEA). FEA sets the qualification criteria for QIs and conducts the training and accreditation processes for them.
So, one good place to start is on the FEA website, where there is more background information on the exchanges and the qualification criteria. The site also features a QI locator, which can help you find the names of QIs in your area who you can then evaluate on your own.
Qualification comes through experience, accreditation
When evaluating a QI company, think about whether you’d be better served with a company that works in only certain locales, or one that has a nationwide presence. Depending on your particular situation, one might be better than another for you. Also, ask about the percentage of staff that hold law degrees and their experience in working on these transactions.
You will also want to determine the financial stability of the company. Many of them are subsidiaries of larger insurance and/or title companies. Irrespective, they will need to speak to their financial strength and their ability to cover any exposure related to your transactions. This is typically done by looking at the amount of errors and omissions liability insurance they carry, as well as the guarantee of funds involved in the transfers.
1031 Tax Deferred Exchange Enhances Asset Value
Typically, when property is sold, any difference between what was made on the sale and what was originally paid for the property is subject to capital gains tax. However, the so-called 1031 exchange, in which like-kind property is exchange, allows any taxes on the proceeds to deferred. With this huge advantage on the table, why is it that more people have not heard about these exchanges, and more to the point, why are they not more widely used?
Part of the answer to those questions lies in the history of the code that defines these exchanges. Until recent years, the requirements were not as straightforward. Today that is not the case. Whereas in the past, 1031 exchanges were perceived as being too complicated. Since changes in the codes governing the taxes changed in 1991, it is no longer the case that they are too complicated. But the value of the exchanges are still not widely understood, though, that too, is changing.
Many benefits of using the exchange
Aside from the tax benefit, there are numerous other benefits associated with 1031 exchanges. These include: exchanges can be used to move from higher interest loans to lower interest loans, they can help people who own a lot of smaller properties combine those properties into one or more larger properties, they can be used as cost-effective way of getting into property that has a better tenant profile, or to get into property in a more ideal location. And it goes on from there. There are many potential benefits associated with the ability to get out of a property without having to pay the taxes associated with the transaction.
Costs associated with exchanges vary
The savings of the exchange can be calculated by estimating the amount that is saved through tax deferment (plus any interest that might accrue during a hold period). However, the costs can be a little more difficult to concretely estimate. But there are some guidelines to consider. First, the cost will depend in large measure on the type of exchange you require. For typical like-kind exchanges, there will be fees of around $1,500 for managing the transaction. Some companies charge additional hourly fees for additional steps that might be required.
Reverse and improvement exchanges require additional charges; these exchanges will likely entail at least an additional $5,000-$7,000, and again, can carry additional hourly charges.
The key is to understand the pricing structure and the estimates from any company you consider working with on the exchange. You should ask for, and they should provide as detailed a breakdown as needed in order for you to understand the cost/benefit of running the transaction in the first place.
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