Successful real estate brokers apply a personal touch to their businesses. They remember birthdays, and ask their clients meaningful questions about their personal and financial goals. They also keep track of where their clients are in their individual life stages. If their clients are nearing retirement age, shouldn’t they want to simplify their financial affairs? Which of their clients have excess funds to invest, and which of their clients should be considering building a commercial real estate portfolio? Have any of their clients relocated recently, and do they still have out-of-State properties that have become a management headache?
A good real estate broker or agent gets a feel for each of his or her clients, and if the professional has kept up to date on real estate strategies, can provide valuable advice and guidance.
Realtors and real estate brokers are in a unique position to help their clients identify and achieve their investing goals, as well as growing the realtor’s business by providing innovative solutions to client needs. When presented with a client that wants you to list for sale his investment property (personal residences do not qualify under Internal Revenue Code Section 1031), the first question the realtor or broker should be asking is “Why do you want to sell this property now?” Some possible reasons for the sale include:
(1) fear of declines in property values—especially when the client has substantial built-in appreciation in the property;
(2) relocating or retirements;
(3) a desire to increase cash flow or generate a steady monthly income;
(4) difficulty in managing the property; and
(5) consolidation of several properties or diversification into additional properties or markets in order to provide protection in the event of a regional decline.
Each of these answers could indicate that the client should explore a 1031 tax-deferred exchange.
Another important question to ask your client who is intending to sell his or her property is: “What do you intend to do with the proceeds of the sale?” If the client intends to purchase new investment property, he or she will definitely benefit from a 1031 tax-deferred exchange—there would be virtually no reason to pay the unneeded taxes that would occur from a sale rather than an exchange. Often, the client will say that he or she is “gun-shy” about the real estate market, or feels that the market is “soft”. Faced with this outlook, you may want to point out that the commercial (rather than residential) real estate market has not seen the rampant price inflation that is evident in the residential market; moreover, office, industrial and shopping center vacancies are at an historic low, so there is still plenty of room left for growth in the commercial market, irrespective of whether the residential market is suffering from oversupply. Finally, you may want to educate your selling client about the flexibility inherent in Code Section 1031 tax-deferred. In a 1031 tax-deferred exchange, an investor can exchange any type of realty for any other type of real estate, including properties that are currently subject to stable long-term leases providing a positive monthly cash flow. Such properties actually act more like a bond that pays interest each month, than a traditional more speculative real estate asset.
The real estate professional should spend a little time becoming familiar with some of the potential benefits of a 1031 exchange. The major benefits include:
Financial Leverage. When the tax liability in a transaction is deferred, the taxpayer receives an increase in available capital, because the federal and State taxes are deferred. All of this capital can be applied to acquiring additional replacement property. Most lenders require a downpayment of approximately 20% on replacement property; thus by using this increased borrowing power, the taxpayer can purchase up to five times the capital they received. This is a major advantage of a Section 1031 exchange when compared with the alternative of a taxable sale. The taxpayer gains financial leverage through an exponential increase in cash flow and appreciation – which provides more buying power.
Minimizing Tax. Minimizing taxes are the most common benefit of a 1031 Exchange. Tax minimization allows the investor to sell one property and purchase a property of equal or greater value while deferring capital gains tax. With depreciable property, gain on a sale is taxed at a flat federal rate of 25% of all depreciation claimed, and a 1031 exchange also avoids this “recapture” of depreciation at this higher rate. In addition, a 1031 exchange defers State income taxes as well as federal taxes and depreciation recapture taxes.
Number of Properties. The investor can sell several properties, and purchase a smaller number, thus reducing management headaches. Alternatively, the investor could diversify his holdings by selling a few properties, and diversifying into many properties. Your clients may also wish to spread his risk over several different States or geographic regions by utilizing §1031, thus avoiding holding properties in areas that have substantially appreciated and where prices have reached their peak.
Diversification. The investor can diversify his or her investments by purchasing properties in several States. An investor could exchange his existing property with a different class of real estate such as long-term leases, shopping centers, raw land, farmland, office buildings, industrial properties, or even percentage interests in large complexes. With respect to real property, Code Section 1031 is very liberally construed in determining what is “like kind” between different classes of real estate.
Cash Flow & Retirement Income. An investor may swap non-revenue producing property, such as raw land or underutilized property, for high-revenue shopping centers, leases of 30 years or longer, or office complexes that already are full of paying tenants. Alternatively, the investor can exchange high-revenue properties for those with greater growth potential such as resort-area acreage or lots in rapidly developing communities. How about avoiding taxes on real estate gains, and re-investing the proceeds in a safe investment that pays the investor monthly income for the rest of his or her life? Shopping centers, strip malls, and office buildings that are already under a long term lease can provide a nearly certain monthly income for the rest of the investor’s life, with rates of return much higher than any government bond. At the taxpayer’s death, all potential capital gains taxes are “wiped away” and his or her heirs will own the property at a “stepped-up” basis, without incurring any built-in taxes that he or she would have been forced to pay if they sold the property without re-investing in a replacement property.
Management Relief. Your client may be too busy or not inclined to deal with management issues, collections, finding new tenants, repairs, maintenance or other headaches that come from owning rental properties. The investor may be approaching retirement age, and thus does not want to be stressed over management issues. Using Code Section 1031, the investor can exchange his high-maintenance property to low or no-maintenance property such as shopping centers that are fully leased with a management team in place, or triple-net leases where the investor owns some or all of a long-term lease, and the owners of the underlying property have to deal with all management issues.
State Taxes and Relocations. Suppose your client’s property is in a high-state income tax state such as New York, Connecticut or California? By swapping for a property in a tax-free State such as Florida, Texas, or Nevada, not only can annual income taxes on rental profits be eliminated, the investor can also completely eliminate State income taxes on the ultimate taxable sale of the property. In many cases, investors desire to move and cannot successfully manage their properties from afar. 1031 Exchanges permit the location of the investment property to change along with the residence of the investor.
If your client is conducting a taxable sale of his or her property, as the listing agent you will receive a commission—none of us work for free. On the other hand, with a 1031 exchange, as listing and purchasing agent, you will receive two commissions– one on the sale for the relinquished property and one on the purchase of the replacement property. If you extend yourself a bit, and explain what you are accomplishing in the 1031 exchange to parties on the other side of the transaction (the buyer of your client’s property for example), you may find that by passing along the details and benefits of the 1031 exchange, the other party often wants to do an exchange with their property as well. By positioning yourself as an expert resource on such issues, brokers and realtors can gain valuable future contacts including potential new clients.
Surprisingly, it is possible to turn a straightforward sale of property into an exchange at the closing table. Often our firm gets a phone call while a seller is at the closing table, and we draft the documents in less than 15 minutes to change a sale into an exchange. The rules of Code Section 1031 provide that the taxpayer has 45 days from the date of sale to identify which replacement property he or she is going to purchase, and the taxpayer has an entire 180 days to actually complete their purchase of the replacement property. In order to properly engage in this type of delayed exchange, the client must engage a “Qualified Intermediary “, which is an independent party that holds the proceeds of the sale and to purchase the replacement property and transfer it to the taxpayer within the 180 days. A good rule of thumb is to already be fully engaged in the process of shopping for one’s replacement property while the sale of the relinquished property is in process. It is never too early to begin scouting for replacement property, as the 45 day rule is absolute—there are no extensions.
To summarize, your position as the client’s broker, agent, advisor and counselor places you in the unique position of being able to add value to the transaction, and to help grow your client’s portfolio by asking questions, listening to your clients’ needs, and providing an innovative solution to your clients’ real estate questions. Your practice will continue to grow as you gain and demonstrate your expertise on variety of real estate investment strategies, with 1031 exchanges being one of the most powerful investing tools still available as a tax and investment strategy.
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