Because of the appreciation of home values in the last year, many cities in the United States are seeing list prices surpassing the “bubble levels” over a decade ago. Now is a good time for investors to exchange properties in expensive housing markets for properties with better cash flow across the country.
The 1031 exchange is one of the most powerful tools for any real estate investor to build wealth. That’s because this tax program allows you to sell your current investment property and use the proceeds of the sale to invest in more properties without paying a capital gains tax.
Title and real estate agents are in a great position to determine who might benefit from a 1031 exchange. Here’s how you can spot an investor who qualifies, explain the amazing benefits of the exchange program, and increase your repeat business with clients.
How can title agents leverage 1031 exchanges to increase their business?
Follow these four steps in order to get more business with real estate investors:
- Learn how to spot an opportunity for a 1031 exchange
- Share the benefits to investors
- Know the basic rules for a 1031 exchange
- Find a trusted Qualified Intermediary
What is a 1031 exchange?
Under Section 1031 of the United States Internal Revenue Code, a taxpayer may defer payment of capital gains and related federal income tax liability on the exchange of like-kind real property held for productive use in a trade or business or for investment. This process is called a 1031 exchange.
Before changes to the tax code in 2018, other types of personal property could qualify for a 1031 exchange including assets like athlete’s contracts, antique cars, airplanes, and other collectibles. Today, only real property is included under Section 1031.
Learn how to spot an opportunity for a 1031 exchange
A 1031 exchange is a great strategy for real estate investors, but not everyone knows about it. If you’re doing a title order for a closing and notice that the seller doesn’t live in the property or that you have to pro-rate rent or security deposits, it's a good sign that they will qualify for this tax deferment.
Real estate agents, title agents, and agent-attorneys looking out for these indicators can introduce the idea of a 1031 exchange to the seller. By encouraging them to think about their long-term investment goals and explaining the benefits, the seller may find it’s the perfect way to grow their portfolio and build their wealth.
“On the West Coast, it's almost commonplace. If it's an investment property or business-use property, boom, escrows contact a qualified intermediary and say OK, run with this. On the East Coast, it's very different because a lot of people don’t know about 1031 and often find out about it a few days, a couple weeks before closing. It's a different dynamic on the East Coast.” - 1031 Corp. President Margo McDonnell
Margo encourages title agents to be the hero of the transaction by sharing this great investment strategy with their clients.
As an added bonus, this is a great opportunity for title agents to increase their title orders with investors. Sellers have a limited time to take advantage of the tax deferment, so be sure to introduce the idea to them sooner than later. You’ll have the chance to get two title orders from the client within 180 days as well as the potential to help them with a refinance on the property later on.
It's a win-win.
Explain the benefits of 1031 exchanges to investors
The brilliance of this strategy is that it allows an investor to build wealth for themselves and their family by deferring a capital gains tax. If they leave their investment portfolio to their children who decide they don’t want to be in the real estate investing game, they can sell the property, BUT they will only have to pay taxes on the profit of the very first 1031 exchange.
Grow your portfolio
This is a great way for real estate investors to parlay one income-producing property into several rental properties. Using the profit from the sale of the previous property, investors can diversify and grow their portfolio. They can increase their net worth tax-free!
Offload underperforming assets
An investor with an underperforming portfolio can use a 1031 exchange to buy properties with a higher value or better monthly cash flow. If the investor currently has a property that is sitting unoccupied or has low margins, this a great opportunity to target other properties of the same or greater price that have better cash flow potential.
There are limitations on when you can sell a property using a 1031 exchange, but there is no restriction on how many times an investor can utilize it in their lifetime. This is a long-term and repeatable strategy to build massive wealth and avoid capital gains taxes. This is how the rich make their money.
Minimize taxes for your beneficiaries
This strategy allows investors to pass down their properties and profits to their children or beneficiaries without paying any taxes on the gains. A “stepped-basis” is applied to the property upon death, which is the readjustment of the value of an appreciated asset at the current fair market value. When the property is passed on to an heir, its value will typically be more than when it was acquired by the investor. Capital gains tax is minimized for heirs because the property is evaluated based on the value and not the built-in gain attributable to the taxpayer. The deferred capital gains taxes won’t be transferred to the beneficiaries.
Using a 1031 exchange allows people to build a legacy of long-term wealth for their family while minimizing the amount of taxes paid.
Know the basic rules for a 1031 exchange
There is a lot more involved in this process, but here are some basic rules that investors and agents need to know:
- The property must be an investment property (not lived in by the owner).
- The property must be owned for at least a year and a day (so flips are not qualified).
- Investors have 45 days within the close period to identify the new properties they will buy.
- The investor’s list should have three properties or less. If they want to buy more than three, the investor will be subjected to the 200% rule. The total combined purchased price of everything on the list can’t be more than twice the selling price of the original property.
- Investors have 180 days to close on the new properties from the sale of the first property. So, title and closing agents need to be aware of these deadlines to ensure they can meet them.
- Investors need an independent third party to hold the money in escrow called a Qualified Intermediary (QI).
- How the investor held title on the old property is how they have to hold the title for the new property.
- All cash gained from the sale must be used for another investment property. Investors must buy equal or more in price and must reinvest all of the proceeds. They can’t pocket some of the money from the sale.
- There’s no requirement that the debt on the new purchase must be equal or more than the debt on the old property.
- Closing agents will need to make some minor changes to the Closing Statement to reflect the exchange, but the transaction is handled like a typical closing. The QI will provide more instructions before closing.
Find a trusted Qualified Intermediary
An investor can appoint any individual or company to be their Qualified Intermediary (QI). Ideally, they will want to choose a trustworthy professional with experience in real estate closings, but they can choose almost anyone.
Exclusions include related parties like your father, mother, sister, aunt, etc., agents of the taxpayer, like a CPA, accountant or attorney, etc. employees of the taxpayer, and your real estate agent. Anyone who has acted within any of these professional capacities for the taxpayer within the past two years is barred from acting as the QI.
Essentially, the QI must be an independent third party with no prior association with the taxpayer conducting the exchange.
What does the Qualified Intermediary do?
The QI assumes the role of a middleman in the exchange in accordance with the 1031 regulations. Some of the things the QI does includes:
- Control exchange proceeds
- Prepare all necessary exchange documents
- Acquire and convey properties through a paper assignment
- Coordinate details with closing agents
- Reminds parties involved in the closing of strict deadlines
Investors will want to choose wisely though as the lack of regulations on people and companies acting in this role can cause a major problem. LandAmerica 1031 Exchange Services, Inc. was a qualified intermediary that held approximately $420 million of its customers' money when it filed for bankruptcy.
When their customers demanded their money back, they discovered that LandAmerica had not held their cash in an escrow or in a trust account. The agreements they signed never delineated that such accounts would be established on their behalf.
Unfortunately, these investors were considered “general unsecured creditors” to be paid after LandAmerica’s secured creditors. In fact, when the court reviewed the exchanged agreements between the customers and LandAmerica, it was noted that the documents transferred to LandAmerica “sole and exclusive possession, dominion, control and use of Exchange funds.”
LandAmerica also didn’t separate the exchange fund from its operating funds. From the exchange agreement, it was clear to the court that the customers intended LandAmerica to treat the funds as its own like a debtor/creditor relationship rather than a trustee/beneficiary arrangement.
Build a relationship with a trusted 1031 exchange company
While there are certificates and courses on 1031 exchanges to demonstrate a QI’s competency, there is no regulation on how a QI can handle a customer’s funds. It is absolutely imperative that real estate investors either work with trusted counsel to review the agreement or carefully read their agreement before working with the QI.
As a real estate professional, investors may ask for your recommendations for a QI, especially if you are the one to suggest a 1031 exchange. Establish a relationship with a reputable 1031 exchange company now, so you can help better guide investors.
Are you currently suggesting 1031 exchanges to the sellers you work with? Let us know how the process has been for you. If there are any other important tips you would share with title agents to get started with 1031 exchanges, tell us in the comments!