A great way to add value to client relationships is to present an opportunity they may not be considering or even aware of. Cue the Internal Revenue Code Section 1031 Like-Kind Exchange. A “win-cubed” outcome is achieved by a combination of the exchanger’s improved reinvestment position, the qualified intermediary’s new-found client and your enhanced value to the client/exchanger as the person responsible for igniting the 1031 exchange spark.
While 1031 exchanges provide huge benefits in many cases, it’s crucial that your client not make the decision to participate in a 1031 exchange over a conversation with you alone, but rather seeks input from a tax professional and, perhaps, legal counsel. You want your client to remember you as the person who encouraged him to explore a wealth building and cash-flow enhancing tool, not as the one who got him into something he later came to regret!
Any reputable qualified intermediary, aka one of the many firms or individuals around the country that facilitate nearly all 1031 exchanges, will advise the same to their potential clients: run your exchange scenario by your tax pro and with their blessing, we’re happy to proceed.
Aside from this central, guiding principle, following are some key aspects of Section 1031 that you, as an exchanger’s agent, adviser, lender or friend are well served to be aware of. The exchanger must establish his 1031 exchange before closing on the earliest of any exchange property to be relinquished or acquired. A like-kind exchange is invalid if not in place, with written notice provided to the other party(ies) involved, prior to the exchanger’s first related closing. Warning: The earlier of transfer of use, payment or deed/title signifies “closing” under Section 1031.
Additionally, you should ensure that the exchanger’s use of relinquished and replacement properties qualify for Section 1031 treatment. Property must “…be held for productive use in a trade or business or for investment.” An exchanger may only have personal use of the relinquished and replacement for 14 days per year, or 10 percent of the days the property was rented, looking backward and forward two years from the like-kind exchange start date. Another warning: Fix-and-flip properties are viewed by the IRS as inventory held for sale and do not qualify.
The following aspects, though not requirements of the code, are critical to a successful 1031 exchange experience. The exchanger should:
Understand the flexibility of Section 1031. If property use qualifies, any type of real estate on U.S. soil is like-kind to any other (and foreign property is like-kind to foreign property). There is no limit to the number or value of properties allowed in a 1031 exchange, nor a cap on how many 1031s an exchanger may participate in. In addition to traditional forms of real estate, Delaware statutory trust and tenancy in common fractional ownership investments are eligible, as are long-term leases, conservation easements and water/mineral rights in states that define such rights as real estate interests.
Ensure they have taxable gain to defer and that the tax deferral via Section 1031 is in their best interest by consulting with their tax professional beforehand. Warning: Deferral of a loss on sale is mandatory rather than optional under Section 1031; the exchanger must be fully aware of his financial situation to avoid getting stuck!
Consider their desire to acquire property of equal or greater value; and their desire or need to partially cash out. For full tax deferral, replacement must be at least equal in value to relinquished, all net proceeds must be reinvested and debt may not be relieved. Outside of these conditions, a portion of the exchanger’s proceeds becomes potentially taxable as “boot” (nonlike kind proceeds received by the exchanger, and therefore taxable). A 1031 exchange with less-than-full deferral still may provide substantial benefits. This is yet another reason for the exchanger to meet with a tax adviser in advance.
Select a reputable qualified intermediary to facilitate the exchange. Look for consistent experience (as opposed to an intermediary who dabbles in 1031 exchanges), the qualified intermediary’s use of a segregated qualified escrow or qualified trust account for each exchanger’s proceeds (some qualified intermediaries comingle proceeds, which is within their rights but adds a degree of risk), professional liability, aka errors and omissions insurance (the state of Colorado and certain other states require qualified intermediaries to carry at least $250,000 of E&O or a $1 million fidelity bond), other insurance protections, certified exchange specialist designation and Federation of Exchange Accommodators involvement.
Postponing large tax bills, accelerating opportunities to build wealth and improving cash flows are serious attention getters! When you have clients whose transactions involve business-use or investment real estate (generally speaking, any properties outside of personal residences and fix-and-flips), introducing clients to, or reminding them of, Section 1031 may prove beneficial to you as well as to them. Temper the mention of “1031” with the notion that tax and, perhaps, legal counsel is an important first step. You’re in position to move forward with a client who’s appreciative, at a minimum, and if a 1031 exchange is deemed to be a good fit by counsel, a client in a stronger financial position for reinvestment and long-term wealth building.