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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   January 2017

The Exchange Game

Section 1031 property deals help clients to maximize returns by allowing them to defer capital gains taxes

The Exchange Game

Commercial mortgage originators play a vital role in helping clients understand the multiple moves that can be made on the property-financing board. One of the most creative moves is the so-called “like-kind” property exchange made possible through Section 1031 of the Internal Revenue Code.

Section 1031 property exchanges allow property owners to defer capital gains taxes when they exchange commercial assets of a similar value. It’s an excellent way for brokers to offer clients who also are real estate investors or business owners a lucrative strategy that will increase cash flow and enhance real estate holdings while also creating an opportunity for the broker to earn income from arranging the financing for the property exchanges.

Section 1031 of the Internal Revenue Code has enabled commercial property owners since 1921 to defer taxation on capital gains when a property held for investment or use in a business is exchanged for another “like-kind” property. Essentially, a 1031 exchange provides a commercial property owner with an interest-free loan they can use over and over as they build equity while acquiring better-performing investment properties.

A 1031 exchange also provides a mortgage originator with a source of additional revenue, as many clients will exchange up in value and into larger replacement properties requiring larger loans. Investors defer gains on the acquisition of a replacement property and their old basis is carried over into the replacement property. Once the investor decides to dispose of the property, they generally will opt to perform another exchange instead of facing an even larger tax consequence on the disposition.

Through a 1031 exchange, commercial property owners can defer up to four levels of taxation, which include the following:

  • Depreciation recapture at 25 percent;
  • Federal capital gains at 15 percent or 20 percent; 
  • State taxes; and
  • The 3.8 percent Section 1411 net-investment income tax, when applicable.

The definition of “like-kind” is very broad for real property and includes land, single-family rentals, commercial and retail, multifamily, farms and ranches, and virtually any type of real property held for investment — including easements, mineral rights and, in some cases, water rights.

Exchange time requirements

The most common exchange variation is the delayed exchange. In a delayed exchange, prior to closing on the sale of the relinquished property, the property owner engages a qualified intermediary (QI) who will facilitate the exchange. The QI, in addition to preparing the necessary exchange documents and safeguarding the proceeds, plays an important role for many parties and helps guide the investor, mortgage originator, real estate professionals, closers, and other parties through the exchange process.

The QI, through an assignment of the sale contract, sells the targeted exchange property to the buyer and instructs the closing officer to directly deed the property to the buyer. The QI then receives the sale proceeds and holds the funds, subject to certain restrictions.

A 1031 exchange provides a mortgage originator with a source of additional revenue, as many clients will exchange up in value and into replacement properties requiring larger loans.

After this closing, the investor has 45 calendar days to identify a replacement property and a maximum of 180 calendar days, or by their tax-filing date — whichever is earlier — to close on the purchase of the replacement property. The QI then, through an assignment of the purchase contract, purchases the replacement property from the seller and instructs the closing officer to directly deed the replacement property to the investor. The QI prepares the assignment agreements, notices of assignment, exchange agreement, written instructions to closing officers and exchange account forms.

For full tax deferral, an investor must meet two requirements: First, they must reinvest the net equity from the sale of their commercial property. Secondly, they must incur the same or greater amount of debt in purchasing the replacement property.

In addition to the delayed exchange, other variations on exchanges can help investors meet other strategic objectives, such as constructing a new property with tax-deferred funds. In a market where inventory is limited, for example, the so-called reverse-exchange parking arrangement allows an investor to close on the purchase of desirable replacement property now and sell the property to be relinquished in the exchange up to 180 days later. As a mortgage originator, this format is the preferred approach because it allows for conventional financing to be arranged for the buyer of the replacement property at the time of purchase.

Vacation-home option

An investor seeking to purchase a vacation home can benefit from a 1031 exchange. A vacation home that has some rental income and some personal use will be considered held for investment if the usage meets the parameters of Revenue Procedure 2008-16.

To meet the requirements of this Internal Revenue Service (IRS) safe harbor, an investor over a two-year period should have at least 14 days of rental income from a property. In addition, personal use of the property should not exceed the greater of 14 days or 10 percent of the number of days that the property is rented out.

Mortgage brokers find 1031 exchanges advantageous, because the investor gains more equity to reinvest in a replacement property.

In this scenario, investors often ask mortgage originators whether they should try to obtain a loan to purchase the property as a second home, or seek a loan to purchase it as an investment property, which would result in a higher interest rate and larger payment. With any 1031 exchange, the investor must initially intend to hold the property primarily for investment purposes.

An investor considering anything other than an investment loan tends to obscure their true intent. Ideally, many facts and circumstances should support the investor’s intent to hold the property for investment, including purchasing it with an investment-property loan.

Refinancing opportunities

An investor may have purchased land for cash that has appreciated significantly, yet creates financial stress because the investor is responsible for the high property taxes associated with owning land and has no offsetting cash flow to help mitigate paying these taxes. An investor can perform a 1031 exchange from land into an improved rental property, which produces cash flow.

Further, because the investor can exchange into a replacement property that can now be refinanced, once the exchange is completed, the investor can work with a commercial mortgage broker to refinance the replacement property. It is important that the refinancing is a separate event and done only after the exchange is completed. If the refinance happens any time during the exchange, the IRS will characterize the refinanced funds as a taxable event.

If the refinancing is done properly and post-exchange, however, the investor can achieve two objectives: They will have acquired an income-producing replacement property generating cash flow to service the new debt, and they will have access to equity through the refinancing that was previously not accessible because it was locked up in raw land. The mortgage broker also benefits from helping the investor tap into a source of significant equity that was not accessible via the land prior to the 1031 exchange into an improved property.

Intermediaries defined

In most exchange variations, the use of a QI is required to successfully complete a 1031 exchange. The QI cannot be a related party, an agent of the taxpayer or a disqualified person. Further, a mortgage broker cannot function as a QI. In addition, the investor’s (or property owner’s) attorney, accountant and employees are disqualified from acting as QIs. A QI does not act as a broker or advisor to the investor. The investor needs the professional expertise of a mortgage broker to obtain input on the best mortgage products to fit their investment-property purchase objectives.

The use of an experienced QI can significantly reduce the complexity of an exchange by assuring the proper execution of required documentation. The QI can help guide the taxpayer and mortgage originator through the exchange process and critical time deadlines. The QI industry is not regulated nationally, although some states have their own regulations. Consequently, the careful selection of the QI is essential to ensure the highest levels of expertise and security of funds. Most reputable QIs are members of the national QI trade association, the Federation of Exchange Accommodators, which can be found online at 1031.org.

Commercial mortgage brokers find 1031 exchanges advantageous because the investor gains more equity to reinvest in a replacement property. The value of a 1031 exchange is more than just tax deferral. It also includes the added purchasing power made available to the investor because all of the gross equity can be reinvested, versus having only the after-tax net equity available for reinvestment after a taxable sale. This means exchange investors can typically qualify for a new loan that is 30 percent to 40 percent larger, allowing the investor to acquire a larger replacement property — and giving the mortgage broker a larger revenue stream, because the fees and points for a 1031-related financing deal are calculated on a larger purchase mortgage.

•  •  •

Mortgage professionals who understand 1031 exchanges get to work with a much larger asset base, allowing investors to take advantage of this powerful tax code provision to achieve a much better return on real estate investments.

With the combination of higher capital gains tax rates and strong appreciation in the real estate markets nationally, many investors are choosing to exchange rather than pay the capital gains tax and other taxes associated with a commercial property sale. Mortgage professionals have the perfect opportunity to help clients while also growing their own business as 1031 exchange transactions gain momentum.


 


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