What’s a Fancy Name for Someone Who Holds Your Money?

Colorado’s real estate market has treated property owners well during the last decade, and many people are considering harvesting significant increases in value. One unfortunate drawback of selling investment and business real estate is that you’ll have to pay your partner – Uncle Sam – a hefty portion of any gain. Even if a property has doubled in value, it may feel as if you’re barely breaking-even after you’ve taken the tax-hit into account. If, on the other hand, you’re able to keep all or most of the proceeds, where and how might you best re-invest them?

You may have heard of a “tax-free” – or more accurately a “tax-deferred” – exchange but may have thought that it’s something cooked-up by hedge fund managers and their hired-gun tax gurus. You may be surprised to learn that these kinds of exchanges take place every day, and most of the people doing the exchanging are not hedge-fund managers or investment bankers but everyday working and investing Americans.

My friend, Ken Palmen, a Regional Development Director with Exchange Resource Group, LLC (“ERG”) has helped lots of clients exchange real estate. “We assist clients of all shapes and sizes successfully complete Section 1031 exchanges (that’s IRS talk for tax-deferred exchanges, which are also called “Starker” exchanges, and “like-kind” exchanges). The law that allows and sets the rules for these exchanges is Section 1031 of the Internal Revenue Code, and that’s why these transactions are usually referred to as “1031 exchanges.”

The rules, while more technical than most of us usually deal with and, in some instances, unforgiving, are pretty simple in concept. If you’ve owned investment real estate or real estate used in a trade or business for more than a year, you can “trade” your property for one or more different properties that you’ll hold for investment or for use in your trade or business without paying tax at the time of the trade. Essentially, you give the IRS an “IOU” for the tax that would have been due if you’d sold the property, and, with some exceptions, you’ll pay the IOU when you sell your new property. Putting off the tax payment may not sound like it’s worth spending any effort, much less money, to accomplish but the benefit you can create by delaying the payment may be surprisingly substantial!

Let’s say you work as a mechanic for a major airline and you’ve saved and invested in a single-family house that you’ve rented for several years. The house is worth about $300,000, and after considering the costs of sale and all the money you spent to buy the house and keep it in good shape, you’ll pocket about $100,000. However, when you talk with your tax preparer, you find out that you’ll have to pay about $60,000 of your profits to Uncle Sam. Your tax advisor used lots of unfamiliar words, like capital gains tax, depreciation recapture, net investment income, and state piggy-back.

In this true story, Ken showed his client how he could keep nearly all the sale proceeds working for him by exchanging his single-family rental property for a multi-unit investment property. The $60,000 that would otherwise have gone to Uncle Sam forever helped to finance the larger property by being available as a down payment. When the client retires in another ten or twelve years that $60,000 could, depending on interest rates and other variables, turn into over $200,000 in equity in the new, larger property. By the way, the new property also generates more rent than the old property. Finally, here’s a third benefit, if you’re into post-mortem scenarios. If the client’s kids inherit the replacement property from the client, they’ll get something called a “step-up” in basis that will effectively mean that nobody pays that deferred $60,000 tax bill.

Ken has helped a wide spectrum of clients, including large companies looking to expand from their current complex to a larger one, wealthy families with holdings all over the country, and blue-collar tradespeople investing in rental property with an eye on retirement. ERG has handled transactions in all of our 50 United States, in Guam and in the U.S. Virgin Islands. (They’re hoping to complete the U.S states, territories, and possessions with the rare property in the Northern Mariana Islands.) On average, Ken estimates that his clients typically defer tax of about 30% of the total gain on their properties.

What may seem to the owner like a small tax savings may still warrant looking into a 1031 exchange. It’s likely that any sale of real estate will kick the owner into the 15% capital gains bracket, if not the 20% bracket. With state income tax, net investment income tax, and depreciation recapture, most clients end up paying tax at a 30 % or greater rate. In one relatively “small” example where the total gain was only $58,000, Ken helped his client defer about $7,500 in taxes that would otherwise have been payable immediately. Most of the transactions Ken works on involve deferring taxes of $10,000 or more, but as long as the client comes out ahead, no exchange is too small.

Ken has helped his clients exchange vacant land, individual condominium units, and small houses all the way up to multi-million dollar residential, industrial, and commercial properties. Ken says that his favorite part of working with clients is helping them, especially if the client wasn’t aware of Section 1031 and how they could benefit from it. As Ken put it, “To help someone further their retirement goals or their life planning goals is very rewarding.”

Property is in high demand in many parts of the country, and you may be forced to buy the property that suits your needs before you’ve sold the property you already own. Will you have to pay the tax when you eventually sell your current property? Ken can explain that he and the other 1031 experts have figured out how to “back into” the exchange using what they call a “reverse exchange.” So long as you jump through all the hoops in the way Ken and his colleagues instruct, the IRS has agreed that you can buy first, sell later, and still defer the tax on the sale of the old property. Ken can also explain how to improve a property as part of an exchange and other techniques for exchanging property in special situations.

Ken and the ERG team have over 90 years’ experience with Section 1031 exchanges. They take great care to apply their experience for the benefit of their clients and will undoubtedly make sure that the “i’s have been dotted and the “t’s” crossed. Ken also strives to help his clients and their advisors feel comfortable by helping them understand the process and the high levels of security his company uses to safeguard their money.

Ken will tell you that there are a lot of rules to comply with to accomplish a successful exchange, and his role is to make sure that clients know all the rules. However, there’s one requirement that clients frequently fail to meet and that no advisor, even one as talented as Ken, can help the client recover from. If the owner has closed the sale without seeking Ken or any qualified intermediary’s help, it’s too late to do a tax-deferred exchange. If the seller touches the proceeds from the sale of the property, no 1031 exchange can be made. With some very limited, fact-dependent exceptions, the IRS doesn’t allow a “Mulligan” or a “do-over.”

Ken’s not a tax or legal advisor. He is a “qualified intermediary” who holds the proceeds from the sale of the old property on behalf of the client and then pays them to the seller of the new property. IRS rules prohibit an exchanger’s direct relatives, associates, employees, lawyers, brokers, and accountants from serving as the qualified intermediary. Those rules also prohibit the exchanger from leaving the proceeds in the closing or title company’s escrow account until buying the replacement property. Ken performs other functions in the transaction, but because these IRS rules limit the role of the qualified intermediary, Ken recommends that his clients rely on their tax advisors and (unpaid promotional placement) legal advisors.

If he was hiring a 1031 exchange professional, Ken would look for the provider who devotes their personal attention to the transaction,  being both accessible and knowledgeable. Since lots of real estate owners include their family members and advisors in discussions about their transactions, the qualified intermediary should be open to discussing the transaction with those parties to ensure that they, too, have an understanding and a comfort level with everything that’s happening.

Ken’s firm offers safeguards such as dedicated, triple-signature-required qualified escrow accounts to provide the protection their clients should expect. Even though qualified intermediaries are permitted to co-mingle client funds, Ken’s firm keeps client funds in separate accounts. This gives the client assurance that a banking or other mistake with another client’s funds won’t spill over and affect – or delay – their transaction, or even cause them the headache of worrying about it.

Ken’s firm educates clients, real estate and business brokers, lenders, tax and legal professionals, and wealth advisors regarding the intricacies of Section 1031 exchanges. Ken will be pleased to help you and your advisors learn how to successfully complete a tax-deferred exchange.

If you might like to meet Ken or introduce him to your team of advisors, I’ll be pleased to connect you. Please feel free to call me at 303-861-1411.