1031 Exchange: Issues
PRACTICAL ISSUES CONCERNING DEFERRED
EXCHANGES UNDER THE FINAL REGULATIONS
First American Exchange Company (A Subsidiary of First American Title Corporation)
When the Internal Revenue Service issued Final Regulations concerning Section 1031 tax-deferred exchanges, we became able to deal with information that afforded the flexibility and certainty that was seriously lacking in the past. For over the last decade, we watched the "delayed exchange" evolve to the point where it became acknowledged as one of the last legitimate tax shelters available to a broad range of taxpayers.
Prior to the Final Regulations, investors, as well as their tax advisors, have shied away from this form of exchange largely due to the uncertainty of the law and their unfamiliarity with the needed concepts to perform a proper exchange. This uneasiness was probably a legacy from the early days of "Starker Exchanges" where the "delayed exchange" was viewed as an aggressive tax concept - a concept that should be considered with some industry suspicion. Skepticism persisted over the years, accelerated by poor practices in the industry.
There has never been a better time for a properly structured real property Deferred Exchange. Under these regulations, what were known as delayed exchanges are now termed "Deferred Exchanges". The immense benefit of such an exchange should be seriously considered by all tax professionals and taxpayers alike. After recent limitations on other real estate tax shelters, the exchange may be the only true, practical tax shelter left in real estate today.
Of course, exchanges are not cure-alls. A Deferred Exchange allows your tax dollars to remain invested in property rather than being paid out as taxes in favor of the government. In effect, the government becomes an investment partner. Funds that otherwise would be dedicated to paying taxes can now be directed, via a Deferred Exchange, toward the purchase of replacement property. One of the principal goals of any taxpayer should be to find property more suitable to their current needs.
A Deferred Exchange makes sense when there is a potential gain on the sale of a taxpayer's property; for example, when the property has highly appreciated and/or there has been substantial depreciation taken on the property to be relinquished. Deferred exchanges have also been recommended for older owners which allows for the potential of a stepped-up basis upon the taxpayer's demise.. Obviously, the continued investment in real estate must make sense and tax considerations alone should not dictate the decision to participate in a Deferred Exchange.
The IRS has served notice on the tax and real estate community that they will be closely watching the Deferred Exchange area. The Service has been uniquely accommodating in providing a reasonable structure to complete Deferred Exchanges. It is imperative that taxpayer observe the established guidelines in order to insure the integrity of their proposed exchange and survive an audit.
Under the Final Regulations, one of the primary benefits of the Deferred Exchange is the ability to close the transaction in stages. This makes the Deferred Exchange a much simpler and more efficient vehicle than a "concurrent exchange". The problems of a simultaneous closing with multiple properties in different locations (not to mention different states) can be nightmarish, at best. With a Deferred Exchange, each closing can be handled independently and conveniently without regard to the timetable for any other closing.
In addition to its involvement in Deferred Exchanges, First Exchange Company is prepared to participate in concurrent exchanges. The documentation is prepared in such a manner that, should the exchange, at the last minute, not be concurrent, no changes or amendments are required. Tax consultants should be aware that the use of a Buyer or Seller as the vehicle for a simultaneous exchange does not appear to qualify under the Final Regulations.
When a taxpayer enters into a Deferred Exchange utilizing First Exchange as the Qualified Intermediary, First Exchange prepares a comprehensive Exchange Agreement which sets forth the respective rights, duties and obligations of both First Exchange and the taxpayer. Other documents for the Relinquished Property that are required by the regulations are also prepared at that time. By allowing First Exchange to submit a pre-prepared Agreement, the exchangor should be able to reduce expenses because less time is required for documents to be reviewed by counsel and/or other tax professional.
When the time comes to close the Relinquished Property, the tax exchangor simply requests First Exchange to step into the exchangor's shoes as Seller and complete the transaction Under the Final Regulations, there must be a formal Assignment of rights under the contract from the exchanger to the Qualified Intermediary and a notice of Assignment given to all parties involved.
All proceeds derived from the Relinquished Property are held by First American Title Insurance Company for the benefit of First Exchange as the Qualified Intermediary. The funds are placed in an interest bearing account with the interest accruing (of necessity) to First Exchange Company under their tax identification number. With the acknowledgment by the IRS that a "growth factor", or the interest, can ultimately be available to the exchangor and will not defeat or compromise an otherwise appropriate Deferred Exchange, the exchangor should take comfort in the knowledge that they will ultimately be paid all of the accrued interest of the full amount held on behalf of First Exchange. As distinguished from other intermediaries, First Exchange, from its inception, has credited to its clients a "growth factor" equal to all interest earned.
Upon closing the initial transaction, the exchangor is required to identify Replacement Property within 45 days. It has been suggested that such identification take place as a written letter to the Qualified Intermediary, but there are various ways of completing the identification requirement, which can be best directed by the exchangor's tax advisor.
The exchangor then negotiates all the terms and conditions for the acquisition of the Replacement Property, which must be acquired within 180 days of the first closing or the filing of the exchangor's tax return (with valid extensions), whichever comes first. When the time comes for the closing of the Replacement Property transaction, First Exchange as the Qualified Intermediary, once again steps into the exchangor's shoes and becomes the buyer, utilizing the funds derived from the Relinquished property closing. Again, proper Assignment and Notice of First Exchange's substitution must be observed.
There are, in fact, three separate transactions that comprise an exchange. They are the Relinquished Property transaction; the Replacement Property transaction and the Exchange transaction, which closes in two stages, the first concurrently with the Relinquished Property and the second concurrently with the Replacement Property. All of these transactions are interdependent and interrelated, as required by Section 1031. It is likewise important that the Qualified Intermediary assist in the proper preparation an the follow-through of the exchange file, so that all requirements of the Section 1031 Exchange are met.
The time which elapses between the Relinquished and Replacement Property closings can be as long as 180 days. Consequently, it is important for the exchangor to have assurance that the funds being held will not be at risk because of the failure of the banking institution holding the funds, or misappropriation by the qualified intermediary. Considering the events surrounding the need to call upon a Letter of Credit under a default by an intermediary, it could be all the more difficult. One should also evaluate the strength of the entity issuing the Letter of Credit. For example, could the bank withstand a call by a number of deferred exchange clients? In addition, Letters of Credit are very expensive. Not only is there a substantial fee, but the Letter must be reviewed by the exchangor's tax counsel to avoid any appearance of constructive receipt of the proceeds.
So, one might ask, why choose First American Exchange Company over another intermediary offering 1031 exchange services? Well, to begin with, First American Exchange Company has been established for the sole purpose of acting as a Qualified Intermediary in I.R.C. Section 1031 Tax Deferred Exchanges. The most unique quality of First American Exchange is its ability to insure funds held during the course of an exchange without jeopardizing the tax status of the exchange. When someone utilizes First American Exchange Company, this protection covers not only loss due to misappropriation of funds, but also failure of the financial institution holding the funds.
It should also be pointed out that the fees due First Exchange Company for performing this service are quite reasonable. A quick look at our brochure will show that in most situations, the "growth factor" earned offsets the additional fees incurred in conducting a delayed exchange. Our brochures can be obtained through any local First American office, who, in turn, can request them from First American Exchange Company.
Most other entities assisting in deferred exchanges have traditionally retained all, or a substantial portion, of the interest earned, in addition to other fees or charges. Many other intermediaries have other fees or costs which are carefully obscured. Also, they often set up transactions in a fashion which may not meet the requirements of Section 1031.
It is important to note that under the Final Regulations, a person who has acted as a taxpayer's employee, attorney, accountant, investment banker or broker or real estate agent or broker, within the two-year period ending on the date of the transfer of the Relinquished Property, is treated as an agent of the taxpayer at the time of the transaction. Therefore, they may be defined under the Final Regulation as a "disqualified person":, calling into question any exchange in which they attempt to act as a Qualified Intermediary. Further, a party related to that agent, such as a spouse, also appears disqualified.
To summarize, the Final Regulations offer taxpayers a unique opportunity to shelter their investment income. No other similar vehicle remains today. With the adoption of the Final Regulations, the element of certainty is finally established to allow taxpayers the flexibility of performing tax-deferred exchanges. We suggest that parties interested in performing a deferred exchange review the advantages of using a Qualified Intermediary, such as First Exchange, as distinguished from other offered vehicles purportedly available in the marketplace today.
It had been our experience that tax advisors throughout the nation have found that the structure utilized in the First Exchange program is one of the simplest and most appropriate methods of accomplishing a tax-deferred exchange. In addition, with the protection and security we can offer through our affiliation of First American Title, the largest title company in the nation, we can provide the exchangor with the assurance that their investments are secure.
Download Entire Issues Document
S.H. SPENCER COMPTON, ESQ.
Phone: 212-850-0647 Fax:212-331-1680