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Article on Qualified Intermediary By Lew Geer There are a few basic rules that distinguish an exchange from a sale and allow you to defer your capital gains tax. One is that you must not receive the proceeds of the sale. Those funds must be held by a Qualified Intermediary, an independent third party defined by the IRS. How should you pick one out, how do they get paid, what are things to be concerned with? These are important questions in any exchange. Actually the IRS does not so much as define what is a Qualified Intermediary as define who would be disqualified and cannot be a Qualified Intermediary of QI. It cannot be anyone with a close relationship to the seller, like an attorney, CPA, banker, anyone related to them, or anyone who works with them or for them. Independence is a critical feature. This brings up important concerns. There are no certification, experience, or education requirements by the federal or state government. A felon could be qualified, as long as they are not defined as disqualified. But the transactions have to be done correctly. They have to follow all rules and be done correctly or the exchange could be disqualified and the transaction could become taxable. You would not want an inexperienced or uneducated QI handling your transaction, any more than you would want an real estate agent or lawyer. Don’t make a choice based on fee or convenience of start up. A crucial concern would be how long they have been in business. Are they established in the community? Are they local? Are they active in their respected trade associations? Have they educated and trained themselves in 1031 Exchange matters? QIs are paid in two ways. They charge a fee for the transaction, and they may earn interest on the money they hold until you complete your exchange. Some firms, including ours charge a fee to start a simple transaction, with additional services available. In most of the country this typically is about $750. If there are more than two properties involved for example, there may be additional charges. Get estimates of all charges before you open the account. A more complex transaction, like a reverse exchange, may cost more. QIs hold your funds in their account until your transaction is closed. Your transaction may not be much, and by definition it will be held for less than 180 days, but in aggregate all the accounts may be a large sum, and get attractive interests from the bank. Safe guards like bonding are important for peace of mind while the QIs are holding your money. It is also a reason to deal with a long term established business with roots in the community. Choose a Qualified Intermediary who is ethical and knowledgeable about the tax laws and IRS code section 1031, and honest about charges and will give your funds the safety you require. By Lew Geer Many parts of a 1031 Exchange are clearly defined and exact, like the 45 period to identify replacements and the 180 day time to close all transactions. Others seem more vague, though there are guidelines to what is acceptable by the IRS. Needless to say, this vagueness can lead to confusions. How long must you have held a property for it to be appropriate for a 1031 exchange. Some exchange experts say you must hold a property for two years. Others say at least one year and a day. Others say holding period is less important than establishing that you intended to hold it for an investment, as compared for a quick turn around or sale. There is some soundness in all of these guidelines. Section 1031 allows you to defer the gain and the tax due if your old and new properties are held for investment or used in a trade or business. It also says the code does not apply for property held primarily for resale. What is the difference? Court cases and established practice give us guidelines to the difference between property held for resale and property held for investment. In most of these cases the court has ruled that it is an investment if you have held for two Tax years. That means your original purchase and sale must be show on different year tax returns. In addition the IRS has decided to audit exchanges if the ownership period is less than a year and a day. This prevents someone from buying a property in December of tax year one and selling one month later in January of tax year two. This also prevents the conversion of short term capital gains to long term , lower rate capital gains by exchange. There have been court cases that challenge this, and a few have been decided that have allowed exchanges in property owned less than a year. But they are a minority of cases, and came about only after an expensive court fight. It is to the benefit of the exchanger to follow the guidelines and hold the property for more than a year and a day, spanning two tax years, and showing the intent of owning a property as an investment. By Lew Geer If you have held real estate for a while, you likely have a gain in value. If you sell it, you will have to pay capital gains tax, which including state and federal taxes, can be approximately 25%. If on the other hand you take advantage of rules explained in IRS Section 1031, you can defer that tax into the future, and use the gain to reinvest in more real estate. There are many steps that are required for an exchange rather than a sale. One requirement is that the property and the old property must both be “held for investment or used in a trade or business”. There can be some confusion about what this means. “Held for investment” does not mean your personal residence, the one where you live. That can be covered with another IRS section. It does not mean property held for resale, for example if you have a short term “flip” type resale. Second homes are a gray area, and can be appropriate for an exchange. The best example for an investment would be a rental property, like an adobe duplex or a piece of vacant land. One rental property can always be exchanged for another, in fact your adobe duplex could be exchanged for an office building or a warehouse, or a piece of land. The land could be exchanged for a farm or an office too. Vacant land is almost always investment property. Residential property that you use is less clear. Show that you rented it or even tried to rent it, and you strengthen your claim that it is an investment. Hang on to any proof incase of audit. Real estate that is part of your business is also appropriate for a 1031 exchange: if you own the building where you keep your office for example. A personal residence does not qualify, but that portion that is a home office might. The rules are less clear, so support your claims. Recently the market allowed people to fix up and flip properties for a profit. These are bought with the intention to immediately resell them, in a few months at most. These would fall under short term capital gains rules, and not be appropriate for exchange. However if you held them for a year and a day, they would be considered long term, and could be exchanged. You can sell one old property and buy more than one new one, or sell several old ones and consolidate into one new one. All should be located within the USA however, or all outside. When is a Reverse Exchange Appropriate? By Lewis Geer A Section 1031 exchange allows you to defer taxes on a gain when you sell and reinvest in real estate, by following IRS guidelines and using a Qualified Intermediary or QI. In a large percentage this is the standard 1031, where procedures are simple. Proceeds of a sale are held by a Qualified Intermediary until the new property is purchased to replace the old one. You never own both. In some situations you might want to close on the new property before you are able to sell the old one. The perfect replacement may come on the market and you have to move on it right away. It is the one you have wanted and you can’t wait for the old one to sell. Or perhaps a sale is delayed at the last minute but you still have to close on the new property or loose it. You can still defer gain and taxes with a ‘reverse exchange’. Your QI can arrange to take title to your new property and ‘park’ it until you close on the sale of the old property. At that point the new one can be exchanged for the old one. The IRS has approved this concept, but the rules are complex and must be followed carefully. You should be certain to work with a QI who knows this procedure well. Usually an LLC is formed to hold the property. It must file tax returns too. This involves legal and accounting expenses. If money is required to complete the transaction, you will have to borrow it short term from a bank. This may be an unusual transaction for them too, though there are commercial banks that are experienced in this area. It is not done through a traditional mortgage lender. This may combine to be higher fees, but compared to the tax savings it can be a great bargain. Plan with your CPA and QI to explore the benefits. |
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