1031 Exchanges: Tips, Traps and Techniques

In the commercial real estate industry, one of the most popular methods for deferring capital gains taxes is to employ the 1031 exchange strategy. It’s very effective but you must do your research.

To qualify as a 1031 tax-deferred exchange, it often requires the involvement of a 1031 Exchange Company or the use of a qualified intermediary to avoid constructive receipt (paying taxes).

One of the purposes of the intermediary company is to keep all of the funds from the properties you just sold while you are looking for a replacement property to complete the exchange.

However, here’s an interesting fact regarding these companies: These companies are not regulated by either the Federal government or any of the 50 states.

What this implicitly means is that these exchange companies can use your money to invest in anything they desire during the interim period. You have no control. And they don’t have to tell you they are doing it.

There have been rather unfortunate stories about exchange companies losing investors capital and then quickly declaring insolvency.

Investors usually recover only a fraction of their money, if any. To add insult to injury, their capital gains may be taxed because they did not complete the transaction in the allotted time.

So the key to success using the 1031 exchange strategy is to pick an appropriate, trustworthy intermediary. There are three main types of companies:

1. Some exchange companies are just division or subsidiary or an entity owned by an escrow company. For example First American Exchange Company (FAEC) is separate Limited Liability Company (LLC) owned by First American, which is also in title & escrow business. FAEC occupies the same office and even has the same phone number as the First American Title office.

2. Some banks, e.g. Washington Mutual (WaMu) or Citibank also offer 1031 exchange services.

3. There are companies that specialize on 1031 exchange. They could be a one-location company or a franchise with offices in many states. For example:

· Equity 1031, LLC; www.equity1031.com.

· Equity Preservation, Inc.; www.equitypreservation.com.

When considering an exchange company, you should research their fees and services in detail. But what’s most important to verify is how trustworthy they are. To ensure your money is safe, you should ask the exchange company if:

· Your money is FDIC insured.

· Your money is deposited in the general account or separated trust account under your name. When the money is in the general account, the exchange company can use it for anything; e.g. pay salary for its employees. Should the company declare bankruptcy, all of your money could be lost. On the other hand, the trust account is intended to keep your money just for own use. The federal government regulates this kind of account and the exchange company cannot use money for its business. So this is a safe account to keep your funds. Normally if you don’t say anything, your money is deposited in a general account.

· Your money is invested in the US. If it’s invested outside the US, there may be a delay from the time you request your money to the time you actually get it.

· How safe your money is. Normally, if the exchange company pays you high interest, that’s usually a strong indication your money may be invested in a higher risk instruments or investment.

In short, do your homework on whomever you choose.

Regarding fees: The fees charged by these companies vary from $200 to $750. However there may be different rules and regulations:

· The company that charges low fee (WaMu charges $200) often does not pay interest on your fund or only pays interest if your fund is above a certain amount. If your sales proceed is significant, e.g. several hundred thousand dollars, you may save on the fee but may lose a significant amount on the interest payment.

· Some companies pay savings account rates. Others may pay higher money market rates.

· Some companies charge higher fee, e.g. First American Exchange charges $750, but may allow you to make as many offers as you want. Each time your offer is accepted, the exchange has to review the contract, and wire the money to the seller's escrow account.

· Depending on the amount of money you have, these fees and interests rates may be negotiable.

The bottomline: You may want to consider a strong institution, even though the rates of interest may be lower or their fees may be higher. Consider it cheap insurance on your hard earned money.

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