What does 1031 Corporation do for You?

1031 Corporation facilitates 1031 exchanges by acting as a Qualified Intermediary. We work directly with real estate agents, attorneys, and tax professionals to provide consultation and guidance throughout the exchange process.

We prepare all documents that the IRS requires in completing an exchange. This includes the Exchange Agreement, Assignment of Contract and Notice of Assignment of Contract. Documents are prepared before the sale of the relinquished property and before the purchase of the replacement property. We provide a form to comply with the identification requirements that the IRS has defined and follow up to make sure the deadlines are met.

The exchange proceeds are banked in segregated accounts for the benefit of the exchange client at FirstBank. We have the ability to provide FDIC insurance up to $6.5 million by using separate accounts within the FirstBank charters. Our clients earn money market interest rates on the exchange proceeds.
Upon completion of the exchange, we provide our clients with a summary of the exchange. The summary includes copies of all documents and worksheets to assist with completing Form 8824. We have a CPA on staff to assist with any exchange related tax questions.

Choose 1031 Corporation. We have the knowledge and expertise to help clients defer capital gains tax and we provide exceptional customer service in the process!

1031 Receiver Recovering Lost Funds

A couple of recent news reports from Las Vegas indicate that former clients of Southwest Exchange may receive a substantial portion of their 1031 exchange funds. Jeff German of the Las Vegas Sun reports that as much as $91.7 million of the $97.5 million previously thought lost has been recovered through settlements with insurance and banking partners of the firm.

This is a remarkable sum considering how it appeared almost two years ago. Reportedly, Southwest Exchange acquirer, Don McGhan, invested nearly half to purchase a breast implant manufacturer and spent millions more to support his lavish personal lifestyle.

Of course, the news is tempered. As much as 25% of the money could go to attorneys that assisted in obtaining the money. Also, those taxpayers did not receive any relief from the IRS on the capital gain tax that they were required to pay (since their exchange could not be completed within their original 180 day window). Still, the news is much more favorable than anticipated and much better than what the latest is on the 1031 Tax Group/Ed Okun scandal.

As we've highlighted before, the central theme to both these issues (as well as the recent Summit 1031 Exchange failure) is the borrowing of monies that were placed in trust for clients into closely held and irresponsible, or downright fraudulent, investments. Both McGhan and Okun were acquirers who found a way to loan themselves millions of client exchange funds. Summit was owned by a sponsor of Tenant In Common Interests that was loaning its client funds to the parent thereby allowing it to leverage real estate.

Recent provisions in California, and now pending in Colorado, will make this activity illegal. No longer will Qualified Intermediaries be allowed to "loan" funds to an affiliate. This is an important element in all these unfortunate scandals. By providing sensible legislation that protects the client and allows ethical Intermediary firms to do business cost effectively, California and Colorado are taking the lead in protecting consumers and business alike.

Development Rights are Like Kind to Fee Interest in Real Estate

A newly released private letter ruling, PLR 200901020, reaffirms the IRS's view that development rights are a qualifying interest in real estate which can be like kind to a fee and other interests in real estate for purposes of an exchange under IRC Section 1031. PLR 200805012 previously affirmed the same. Accordingly, development rights can be exchanged for a fee interest in real estate and vice versa.

In order for development rights to be like kind to fee interest in real estate under IRC Section 1031, it is necessary for the state the rights are located in to view such rights as a real estate interest and for the rights to be in perpetuity (as distinguished from rights which are short-term or for a limited period of time). Perpetuity is important. Short-term rights may be an interest in real estate under state law but are not like kind to a fee interest in real estate under IRC Section1031. PLR 200901020 makes this clear.

A qualifying interest in real estate which can be like kind to a fee interest in real estate under IRC Section 1031 can include varying types of real estate interests. PLR 200901020 examines such other types of qualifying interests in real estate including –

• Leasehold interests of 30 years or more
• Easements
• Rights-of-ways
• Water rights
• Mineral rights
• Royalty rights
• Mineral leases

All of these types of real estate interests are considered like-kind to each other under IRC Section 1031 and may be exchanged for each other.

While the privage letter ruling can not be cited as precedent, and the IRS has the right to rule differently on subsequent occasions, it is a useful ruling for the purpose of demonstrating the IRS's view for similar situations. To receive a copy of the PLR, give us a call at 888-367-1031 or send us a message at 1031@1031cpas.com.

States Begin Regulating 1031 Exchanges

In September, California signed a law that became effective on January 1, 2009 regarding companies facilitating 1031 exchanges. The new law holds Qualified Intermediaries (QI) to new requirements on property exchanges taking place in that state. California wasn't the first - Nevada and Idaho had previously approved legislation on the Qualified Intermediary industry. But, California passed legislation that has the intent to protect consumers while minimizing costly and burdensome regulation to 1031 exchange companies that was sure to be passed on to consumers.

The California 1031 law has become a model of consumer protection for other states, such as Colorado, Arizona and Washington, now considering similar legislation. Some of the requirements include requiring 1031 exchange facilitators to maintain bonding and insurance. They require Qualified Intermediary companies to notify clients of any change in the company's control (as in a sale or other controlling change in management). The California law also requires exchange companies to invest exchange client funds in a way that meets “prudent investor standards”. This last point is, perhaps, the most important measure included. No longer will exchange companies be able to loan funds to affiliates or owners to fund other "investments" (bank-owned Qualified Intermediaries are exempt when depositing funds in bank accounts with a parent bank).

This follows on the heels of a recent industry failures that have affected a significant number of 1031 exchange clients. A couple of high profile cases involve 1031 Tax Group and Southwest 1031 Exchange. LandAmerica Financial Corporation's recent bankruptcy filing (due to LandAmerica Exchange's lack of liquid investments) reiterated the point that additional guidance and regulation was necessary. Exchange intermediaries that are found to have not held the funds in a prudent manner - or otherwise fail to meet the "model law" requirements - could be subject to civil and criminal penalties. It also gives some recourse to injured exchange clients to file a claim against the required bonding, cash deposits, or letters of credit.

States that follow are using the California "model law" as a template for sound, practical legislation that doesn't create undue burden on exchange companies while, at the same time, providing protection to consumers. Each state, most likely, will have their own changes to the model. But the California 1031 law is a welcome trend for ethical, prudent exchange companies and the clients that employ them to facilitate their 1031 exchange tax strategy.

The Compounding Effect

The following post is a portion of an article written by Ronald Raitz and appearing in the Sept/Oct edition of Commercial Investment Real Estate, The official magazine of the CCIM.

When Albert Einstein was asked, “What is the most powerful force in the universe?” His reply was, “Compound interest.” People in the financial services industry understand the effects of compounding: For example, whether an investor starts funding an individual retirement account at age 20 or 40 results in a dramatically different retirement balance at age 59½. The simplest of illustrations — the “double the penny” example — further highlights the sometimes surprising benefits of compounding: A penny doubled every day for a month is worth only two cents on day two, but on day 31 it is worth $64 million. Compounding plus time can indeed produce impressive investment growth.

Potentially the most powerful benefit of a 1031 exchange, the compounding effect also is the most overlooked. The key to getting the highest compounding result is keeping all of the money working for the investor — not only now but also into the future. In an exchange, the amount of tax that otherwise would be paid is reinvested. The projected future value of the compounded yield on the deferred tax becomes very substantial over time.

Many real estate investors also add leverage, which significantly amplifies the compounding effect. For example, in 1988, an investor who possessed strong management skills sold a $1 million property that had a $200,000 basis. Without utilizing an exchange, the gain on the sale would have been $800,000 with approximately $200,000 in taxes due. After paying the taxes, there would have been approximately $800,000 after-tax cash to reinvest.

But the investor exchanged the property and bought a $1 million income-producing replacement property that was 85 percent occupied. He put $200,000 down — exactly the same amount he otherwise would not have had without the exchange. Two years later, after making necessary management adjustments, he increased the property’s occupancy to 94 percent and sold it for $1.4 million. The $200,000 that he put down on the property (money that would have been used to pay the recognized gain in 1988) added to the $400,000 he just made equals $600,000.

The investor did another exchange and put the $600,000 in proceeds down on a $2 million income property that had been under-managed and was at 83 percent occupancy. Three years later, after achieving 92 percent occupancy in the property, the investor sold it for $2.6 million. With the $600,000 he had put down plus the $600,000 he made on the sale, after only five years the $200,000 tax that was deferred had grown to $1.2 million. Alternatively, without the exchange strategy the investor would have had no compounding benefit from his investments because the initial $200,000 would have been paid to cover the tax obligation.

Compounding combined with leverage can build wealth very quickly. Over a 12-year period, this investor did five exchanges and turned the money that he otherwise would not have had ($200,000) into $4.8 million.

Many investors have developed exchange strategies that have enabled them to go from a modest net worth to a very high net worth in a 10- to 20-year time frame. Clearly, these real-life examples are achieved more easily when real estate is in an up cycle, but this does not negate the potential benefits of employing a 1031 exchange strategy and holding real estate through the down cycles. Over time, the investors still come out far ahead of where they otherwise would have been if they had sold, paid the tax, and gone into an alternative investment.

Since there are no restrictions on the number of exchanges a taxpayer can complete, this strategy can be used during the taxpayer’s entire lifetime. Although some investors eventually sell property that is acquired via an exchange and pay the tax, it is very common to never cash out and carry investments into the taxpayer’s estate. At that point, the estate receives a stepped-up basis and the tax consequence disappears.

Section 721 Exchange into an UPREIT

A REIT is a Real Estate Investment Trust whose stock is publically traded. An UPREIT is a real estate investment operating partnership in which the REIT is the general partner and real estate investors are limited partners. A Section 721 Exchange is the method by which real estate investors can transfer a real estate investment into an UPREIT tax-free (or tax-deferred). Internal Revenue Code Section 721 deals with contributions of real estate to an operating partnership in exchange for an interest in the partnership.

UPREITs use IRC §721 to acquire property from investors who want to exchange out of their real estate investment into an investment which is managed by professionals. Subsequently, at a point in time which is suitable for the investor, UPREIT partnership ownership units are exchanged for shares for publically traded stock in the REIT which are then sold on the securities market. The exchange of units of the UPREIT operating partnership for stock shares in the REIT is a taxable event. But this is done at the same time that the REIT stock shares are sold so at this time the investor is cashing out of all or part of his investment at capital gains rates. This arrangement provides professional management and liquidity to the real estate investor.

In order to contribute an investment property to an UPREIT, the property must meet the REIT's investment criteria which generally include a requirement for institutional-grade property. If the real estate investor's real estate is not institutional-grade, he can convert his real estate to institutional-grade real estate with a sale and exchange through IRC §1031 and replacement with an investment in a syndicated tenancy-in-common (TIC) investment. Then, the TIC investment can be contributed to the UPREIT in exchange for ownership units in the operating partnership of the UPREIT.

Insist your QI Hold Funds in a Segregated Exchange Account

Qualified Intermediaries (“QIs”) use a variety of ways to bank and invest funds they hold in escrow or trust for their 1031 Exchange clients. QIs have a fiduciary responsibility to hold client funds in a safe and liquid manner. At the present time there is no industry standard for how funds should be held by QIs or how funds should be invested. The most common ways are as follows -

Segregated Accounts – Many QIs, like 1031 Corporation, open separate bank accounts for each 1031 file that they open. The accounts are usually money market accounts which are under FDIC protection and are opened in the name of the QI as escrow holder for the client and include the client’s federal identification number. The accounts usually bear interest which is reported on year end Form 1099 to the client.

Pooled Accounts – Many QIs pool all of their client 1031 funds into one bank account or investment. This is the common way large QIs manage money they hold for their clients. Many smaller QIs also use this method of holding 1031 funds.

Several recent scandals and failures in the 1031 Exchange industry have occurred with QIs using pooled accounts. In some instances, the pooled accounts were invested in other companies owned by the owner of the Qualified Intermediary company. In other instances, the pooled accounts were reinvested in securitized investments which have lost value in the current financial “melt down.”

Land America is apparently the latest casualty of the Pooled Account type of QI. They are reported to be holding $290 million of client exchange funds invested in securitized investments called Auction Rate Securities. The securities have become illiquid and Land America is attempting to meet client obligations from other operating accounts.

Our recommendation is to always insist that your QI hold your 1031 funds in a segregated account subject to FDIC protection.