The latest challenge to the free flow of transactions in the commercial real estate market involves a “1031 Exchange”. These transactions, named after the Section 1031 of the Internal Revenue Code allows for a deferral of any gain that results from the sale of a property, if the proceeds of the sale are reinvested in a similar or “like kind” property.
The tax deferred exchange can be simultaneous or it can be delayed. It can also involve multiple parties.
In a delayed exchange, the proceeds of the sale of the “relinquished” property are held by a third party known as a Qualified Intermediary until a “substitute” property is found. The Seller has 45 days after selling his property to identify a several possible new properties and 180 days in which to acquire one of the identified properties. In the meantime, the proceeds of the sale are held by the Intermediary.
In many cases the Intermediary is allowed to invest the money they are holding for a seller in some safe instrument and retain any interest earned on the money. In the last year or so, several Intermediaries have had to file bankruptcy because the investment instruments turned out to be illiquid and the Intermediary was not able to fund the purchase of the substitute property. In this case, a seller may be liable for the taxes in the gain from the sale of the first property and have little or no money left to either pay the tax or buy another property.
The lesson learned here is that is very important to perform proper due diligence on any Intermediary which focuses on the overall financial health of the Intermediary and where your money will be invested until the substitute property is acquired.
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I'll go a step further Bill and say that during your due diligence, you should run (and not walk) from any Intermediary that does not put your funds into a segregated account using YOUR taxpayer ID on the account, in a well capitalized FDIC insured institution. Period. The concept of taking escrow money and investing it in ANY vehicle is mind numbing.
ReplyDeleteSection 1031 is an extremely powerful gift in the US tax code, but unfortunately not regulated...so choose your QI with as much, if not more care than you would your legal professional, real estate professional, etc. This is not an area to go bargain shopping or get lulled into a false sense of security because your dealing with a "large" company.
John:
ReplyDeleteI agree completely. Thanks for your comment.