Trouble for some tax-deferred 1031 exchanges
Tuesday, September 11, 2007
I'm a pretty plain vanilla investor, and it's situations like those detailed in a recent Bloomberg story on 1031 exchanges that keep my market maneuvers simple.
Before getting to the news story, let's detour just a minute to look at 1031 exchanges. These transactions are named for the tax code provision that allows for the deferral of capital gains taxes on business or investment property that is exchanged for a similar property. You also might have heard them called like-kind or, if you're a seasoned (sounds better than "old," don't you think?) tax watcher, Starker exchanges.
Please note a few key words in connection with the process.
First, "business or investment." The properties involved in the swap must be, according to tax law, "held for productive use in a trade or business, or for investment." So you and a friend can't trade your homes that are worth more than your residential sale exclusion and avoid, at least for a while, taxes on the transaction.
Next, "exchange." My swapping example above was for illustrative purposes only. You don't actually trade properties in the conventional sense of the word. You typically sell your first one, then use those proceeds within a specified time to buy another property.
Then there's the very important "deferral." That's right. You don't escape the taxes. You just get to delay them until you ultimately sell the property that you acquired in the exchange.
Finally, we have "similar." Simple, right? But remember, it's tax law we're talking about, so
Take, for example, the IRS discussion of this issue:
Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Confused? Me too. So I did little more surfing and found, over at the Federation of Exchange Accommodators (the Professional Trade Association for Qualified Intermediaries under IRC §1031), that "all qualifying real property [i.e., real estate] located in the United States is like-kind."
Once you've worked out the property similarity issue, then you have related party restrictions and holding period limitations, not to mention all the different types
Intermediary irregularities: Whew! That's why you definitely need professional guidance in the 1031 exchange arena. And the transactions also must be handled by qualified intermediaries.
According to the previously mentioned Bloomberg story (see, I finally made it back there), "Exchange companies became popular during the mid-1990s after Congress streamlined the deferral law. They typically charge fees of about $500 to $1,500 per transaction and take a share of the interest earned on the money they're holding. Some are paid incentives by banks for opening new accounts."
Unfortunately, not all exchange companies are of similar quality. And that's caused some major problems for folks who thought they were making tax-smart financial moves.
The Bloomberg article looks at investors who've lost the proceeds of their property exchanges because the 1031 companies that handled them went bankrupt. Owners of the bankrupt firms, says the news service, are accused of using client funds to invest in other businesses, emptying bank accounts of more than
Meanwhile, in the wake of the collapse we have the inevitable lawsuits that are trying to recover the losses. Investor claims range from tens of thousands of dollars to more than
The situation also has prompted calls for oversight of 1031 intermediaries, an industry in which the the property middlemen have temporary custody of about
Like I said up front, while things like 1031 exchanges are intriguing with their possibilities of big bucks, our nest egg is doing OK with our real estate investments limited to a REIT fund. And, particularly in light of the issues raised by the Bloomberg piece, I'm sticking to that basic investment strategy.
Great information and very well presented.
I wanted to clarify a few points in terms of the Qualified Intermediaries that have misappropriated clients' 1031 exchange funds.
It is important to note that the two gentlemen that are involved both specifically bought Qualified Intermediary companies in order to use the 1031 exchange proceeds (clients' 1031 exchange funds) for other purposes with the intent to pay them back. No matter how you slice and dice this one, it was still not a prudent move.
The key issue here is that they were not and are not part of the mainstream 1031 exchange industry. They bought there way in over an 18 month period and then hurt good people.
The 1031 exchange started in 1921 and the Qualified Intermediary really got started with the passing of the 1986 Tax Act. There have been relatively few problems in the industry and most of the Qualified Intermediaries have been doing a great job for many years.
You must do the proper due diligence when evaluating your Qualified Intermediary, including checking and verifying their fidelity bond coverage, their errors & omissions insurance, their experience and expertise, and their track record, including how long the current management team and ownership team has been in place. Any recent change in management or ownership should be scrutized carefully.
There you have my two cents.
Posted by: William | Wednesday, October 31, 2007 at 08:42 PM
1031's can be really advantageous, but at the same time, they can cause a lot of confusion. You can't really depend on intermediaries to do everything for you. It's always best to plan your exchange so you don't end up with a big tax bite. I recommend using DeferEm.com to visualize your exchange before initializing your transaction with an intermediary.
Posted by: C.West | Wednesday, September 12, 2007 at 03:05 PM
Wow ! Excellent Article. When we talk about business or investment property it is necessary to talk about the tax code provision that allows for the deferral of capital gains taxes based on 1031 exchanges. Thanks for sharing these key things with us.
Posted by: Investment | Wednesday, September 12, 2007 at 07:45 AM