Every time a client presents me with an opportunity to participate in an IRC Section 1031 transaction, I insist that he or she had his or her accountants run the numbers to determine the effect of paying the taxes versus deferring the tax with an exchange. From my vantage point, the tax savings do not replace the need for a strong real estate transaction for the replacement property. I believe you make money buying real estate; which is best demonstrated when you sell real estate.
Many times, investors are working on a project that will be part of a 1031 Exchange. There's an entire chapter in this book about exchanges, but in a nutshell, a 1031 Exchange occurs when you sell one property and purchase another property under the tax code 1031 and minimize or avoid paying taxes on the gain. Anytime a 1031 Exchange is involved, you should have a qualified intermediary execute it. The reason is simple. If there is any misstep with the procedures of the exchange, you will not qualify and you will end up paying the taxes you were trying to avoid.
You want to know exactly how much the tax is and weigh the pros and cons of the exchange. A good test in my opinion, is asking yourself whether or not you would go forward with the transaction if an exchange was not involved. In other words, would you still consider this opportunity a good investment? Even if you answer yes to this question, I always make sure my client has discussed the exchange with me and his or her tax advisor so the entire plan can be viewed in light of the investor's bigger financial picture.
There are also nontax reasons for exchanges. Here are a few that you may not have considered:
• Exchange from fully depreciated property to a higher value property that can be depreciated.
• Exchange from non-income-producing raw land to improved property to create cash flow.
• Exchange to meet location requirements.
• Exchange from a larger property to several smaller properties, used to divide an estate among several heirs or for retirement reasons.
• Exchange from a tenants-in-common interest in one property to a fee interest in another property.
So what do you look for in a qualified intermediary? Exchangors must feel confident that exchange funds will be safe and available for the successful conclusion of their exchange. It is best to hire a qualified intermediary that, first, comes highly recommended by other real estate investors. You should also do your own due diligence to determine how the intermediary is investing funds it has on hand. Recently, a large intermediary was unable to fulfill its funding obligations because it had invested the bulk of its funds in auction rate securities, which became illiquid overnight! If you cannot understand the nature of the intermediary's underlying investments, then you should not let the intermediary hold your money!
Second, be sure to obtain a written guarantee for the exchange of funds. And, finally, verify that the qualified intermediary has fidelity bond coverage, preferably in the amount of $100 million professional liability insurance and employee theft and dishonesty coverage.
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