One of the most powerful tools in a real estate investor’s bag of tricks is the 1031 Exchange. When used properly it can defer the tax on capitals gains almost indefinitely.
A 1031 Exchange is really very simple. You don’t actually have to trade one property for other… you just must use the gain from the sale of a income producing property to buy another income producing property. There are a few simple rules you must follow. One rule is that you have to complete the transaction within a prescribed time period.
The other requirement of a 1031 Exchange is that you must never personally touch the money from the sale of the first property. Certain people and companies are in business to act as an “Intermediary” in exchanges. Their primary job is to collect and hold the funds from the buyer of the first property and deliver them to the seller of the property you are acquiring. And that’s where the trouble starts.
In the past few years some Intermediaries have disappeared and the funds they were holding from many deals vanished along with them. Often the investor’s losses amounted to from hundreds of thousands to millions of dollars.
Oh yes, there have been other problems. Some Intermediaries “co-mingle” the monies they are holding for exchangers. That means that all of their exchange client’s money is held in one account under the Intermediary’s name. If the Intermediary is sued for some reason all money in the account may be frozen. If the freeze lasts beyond the prescribed time limit (180 days) for exchanges the investors are out of luck. There are no extensions possible of the 180 day deadline. Now the investors must pay income tax on all those capital gains.
With the huge increase in real estate values in many areas recently, investors should be using 1031 Exchanges. There is just no better way to protect their profits and build net worth. But they must also protect those profits from careless intermediaries.
Make sure that your exchange funds are held in a separate exchange account that holds only your money and no one else’s. That account must be separate not only from other client’s monies, but also separate from the intermediary’s assets.
Each of the accounts should have the client’s name on it something like this: “The Exchange Kings, as intermediary for Barbie and Ken Investor”. That account must have the investor’s tax ID or social security number on the account. Now, no matter what goes wrong with the intermediary, your exchange funds will remain protected and accessible.
It’s great to exchange a property for profit. Just don’t exchange that profit for an unexpected loss.