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T H E E X E T E R EXCHANGE The Newsletter for Customers of Exeter 1031 Exchange Services, LLC Volume One Issue 1 Choosing the Look Before Right Qualified Intermediary The 1031 exchange Qualified Intermediary (often YOU LEAP Because tax-deferral and tax-exclu- liabilities are merely deferred — and referred to in the real estate sion strategies are plentiful, it’s impor- can be continually and indefinitely industry as an Accommodator tant for you to consider all available deferred — into like-kind replace- or Facilitator) plays a critical options before proceeding with a spe- ment properties acquired as part of a role in a successful 1031 cific tax planning strategy. Here’s an series of 1031 exchange transactions. exchange transaction. You overview of what’s available: A 1031 exchange allows you to should, therefore, choose your Qualified Intermediary, or QI, with care. The QI is authorized under Section 1.1031 of the Department of Treasury Regulations and is responsi- ble for: (1) preparing the 1031 exchange legal agreements and related transactional documents in order to properly structure the 1031 exchange transaction; (2) receiving, holding and safe- guarding your 1031 exchange Section 1031 — Exchange of sell, dispose or convert real property funds throughout the transac- Property Held for Investment without reducing your cash position tion; and (3) advising you by paying capital gain or deprecia- regarding the implementation Section 1031 of the Internal tion recapture taxes. This provides of your 1031 exchange trans- Revenue Code provides that property the liquidity necessary to increase action to ensure compliance held as rental or investment property your real estate portfolio by trading with applicable Internal or property used in your business up in value and ultimately increasing Revenue Codes, Department ("relinquished property") can be your net worth by improving cash of the Treasury Regulations exchanged for like-kind property also flow and capital appreciation from and related Revenue Rulings held as rental or investment property the portfolio. and Procedures. or property used in your business Continued on Page 3 ("replacement property") allowing you Qualified Intermediaries Are to defer your Federal, and in most Not Regulated cases, state capital gain and deprecia- tion recapture income tax liabilities. QIs are not licensed, regu- This applies to real and personal lated, audited or otherwise property. monitored by any regulatory Note that 1031 exchange transac- body. In addition, they are not tions are tax-deferred exchanges — 1031 Exchange Services LLC required to be bonded or not tax-free exchanges — as many insured, nor are they required National Corporate Headquarters speakers, authors and advisors fre- 402 West Broadway, Suite 400 Continued on Page 2 quently refer to them. Capital gain San Diego, California 92101 and depreciation recapture income tax Call 866.393.8377 for the office nearest you 2 THE EXETER EXCHANGE Choosing an Accommodator Continued from Page 1 to maintain any other form of but often do not know what to city records for criminal convic- minimum equity capitalization. look for when reviewing your tions, civil liens or judgments, Anyone can become a Qualified transactional documents, or will credit or collection problems, and Intermediary and begin adminis- not review them out of concern for more. Prospective employees tering tax-deferred exchange their own liability. should also be screened for illegal transactions. You should always You should ensure that the substance abuse issues. perform a thorough due diligence employees of the Qualified In addition, members of the review of a QI’s qualifications Intermediary have sufficient tech- Federation of Exchange before making a final decision. nical depth, knowledge, experience Accommodators (FEA) also require Never pick your QI based solely and expertise to assist with struc- employees that control, manage or on their 1031 exchange fees and turing your 1031 exchange, review- otherwise handle or have access to charges. Choosing the wrong QI to ing your transactional documents clients' assets to be fingerprinted. administer a 1031 exchange can be for potential problems, and in the The FEA also performs another costly due to critical fiduciary drafting of your 1031 exchange criminal background check when responsibilities and obligations the fingerprint cards are submitted throughout your 1031 exchange for processing. transaction. Institutional QIs will have sophisticated internal audit Due Diligence Process controls to ensure the safety of 1031 exchange funds. They include There is very little written or checks and balances, including a published guidance or reference requirement that multiple parties material available regarding safe initiate any disbursement of funds, business practices for 1031 processing of checks, wire transfers, exchanges and safeguarding your daily balancing and reconciliation 1031 exchange assets. of all fiduciary bank accounts. Often, investors focus on issues In addition, 1031 exchange such as exchange fees, interest agreements. When interviewing administration processes should rates paid, turn-around times and prospective 1031 exchange be segregated from operational branch office locations when advisors, ask lots of questions and functions such as cash management interviewing potential Qualified compare their answers and and balancing. Intermediaries. While many of technical depth of experience in these are important considerations order to separate the true 1031 Safety of 1031 Exchange Funds and should not be ignored or exchange experts from the rest. overlooked, there are other more Qualified Intermediaries hold important criteria when evaluating Internal Audit Controls significant 1031 exchange funds a QI. on behalf of multiple clients with Sophisticated internal processes no regulatory oversight or require- 1031 Exchange Technical and internal audit controls will ments for insurance, or bonding. Capability — Knowledge, minimize the risk of loss to your Most investors never ask how Expertise, and Experience 1031 exchange assets while being their 1031 exchange funds will be held, managed and safeguarded by protected or if they are insured. The most frequent problem your Qualified Intermediary. We recommend you investigate encountered in the 1031 exchange Internal controls monitor and the methods and structures used industry is that many Qualified safeguard 1031 exchange funds to protect your 1031 exchange Intermediaries do not have the during the administration of your funds. Ensure that the QI maintains technical depth, experience and 1031 exchange transaction. appropriate levels of bonding expertise necessary to review the Sound internal processes and and insurance coverage and is transactional documents and catch controls begin with employee adequately capitalized to cover problems before the transaction recruiting. Hiring should always any losses due to administrative closes. Many QIs know how to include a complete background mistakes, errors or omissions. process 1031 exchange transactions check of Federal, state, county and Continued on Page 4 3 THE EXETER EXCHANGE Considering the Options Continued from Page 1 Section 1032 — Exchange of ment property is contributed into a Corporation Stock for Property REIT in exchange for shares of stock in the REIT under Section 721. Section 1032 of the Internal The 721 exchange does not have Revenue Code provides that no to be processed in conjunction with gain or loss shall be recognized to a a 1031 exchange. You can simply con- corporation on the receipt of money tribute rental or investment property or other property in exchange for you already own directly into the stock (including treasury stock) of REIT as part of a 721 exchange. such corporation. Section 721 can provide you an excellent exit strategy by enabling Section 1033 — Involuntary you to exchange out of your invest- Conversion (Eminent Domain or ment real estate portfolio and into Natural Disaster) shares of a REIT. The REIT should provide more liquidity once it If your property is the subject of a becomes publicly traded and listed compulsory or involuntary conver- on a securities exchange. In addition, sion from condemnation via an emi- you gain complete control and flexi- nent domain proceeding by local, bility over the recognition of the state or Federal government, you capital gain tax by determining the may qualify for Section 1033 of the Section 1035 — Exchange of timing and the quantity of shares Internal Revenue Code. This section Life Insurance, Endowment sold in the REIT. provides that real property can be or Annuity Contracts The 721 exchange eliminates your exchanged by you on a tax-deferred ability to exchange back into real basis for "like-kind" real property that Section 1035 of the Internal estate and defer your capital gain is similar or related in service or use Revenue Code allows you as owner taxes by using a 1031 exchange to the property that was involuntarily of a life insurance policy, endowment, because you own securities instead converted. or annuity contracts or policies to of a real estate interest. You have up to two years to exchange or swap these contracts for replace property destroyed by a other life insurance, endowment, or Section 453 — Capital Gain natural disaster, sometimes referred annuity contracts or policies and Deferred with an Installment Sale to as an Act of God, and up to three defer the income tax consequences. Carry Back Note years to replace property converted because of a condemnation via emi- Section 721 — Exchange of Section 453 allows you to defer nent domain proceeding. Property into A Real Estate your capital gain income tax liabili- Investment Trust (REIT) ties when you carry back a promis- Section 1034 — Rollover of Gain sory note on the disposition, or sale from Sale of a Primary Residence Section 721 of the Internal of your property. This is often Revenue Code allows you to referred to as seller carry-back financ- Section 1034 of the Internal exchange your rental or investment ing or installment sale treatment. Revenue Code was repealed and real estate for shares in a Real Estate When you sell your property and replaced by Section 121 of the Investment Trust (REIT). This is carry back a promissory note to help Internal Revenue Code. Still, it is called a 721 exchange — also known the buyer finance the acquisition of important to understand the origin as an up-REIT or 1031/721 exchange. your property, you can defer the of Section 1034, what changed with You would typically utilize the recognition of your capital gain its repeal and the differences between up-REIT when you sell relinquished income tax liabilities until you receive the old and new laws. property and acquire like-kind principal payments over the term of Section 1034 allowed an owner replacement property pursuant to the promissory note. of real property used as a primary Section 1031 of the Internal Revenue Depreciation recapture cannot be residence to sell or otherwise dispose Code. Once held as rental or invest- deferred with an installment sale and of the primary residence, deferring ment property for 12 to 18 months or should be recognized in the year in 100% of the capital gain tax liability more to demonstrate your intent to which the disposition (sale) occurs. by acquiring another primary hold the property and qualify for residence of equal or greater value. 1031 exchange treatment, the replace- Continued on Page 4 4 THE EXETER EXCHANGE Choosing Exchange Options Continued from Page 2 Continued from Page 3 the $250,000 or $500,000 exclusion lim- itation. Bonding and Insurance Section 121 — Exclusion of Capital For example, your primary resi- Gain on the Sale of Primary dence could be converted to rental or Errors and Omissions Residence investment property and then sold as insurance is perhaps the most part of a 1031 exchange after it has important insurance coverage The Taxpayer Relief Act of 1997 been rented for a sufficient amount of for a Qualified Intermediary to repealed and replaced the tax defer- time in order to demonstrate your maintain — even more impor- ral "rollover" provisions contained in intent to hold the property as rental tant than Fidelity Bond coverage Section 1034 with a tax-free capital or investment property. This would — because human error is more gain exclusion provision pursuant to allow you to dispose of your primary likely to occur than theft or Section 121 of the Internal Revenue residence, defer all of the capital gain embezzlement of funds. Most Code ("121 Exclusion"). tax liability, and diversify and allocate institutional Qualified You can sell real property held the capital gain tax liability pro rata Intermediaries have Errors and (owned) and used (lived in) as your over a number of rental properties, Omissions insurance coverage primary residence and exclude from clearing the way for further financial, limits between $2 million to your gross income up to $250,000 in tax and estate planning opportunities. $5 million. capital gains if you are single, and up There are special rules applicable Inquire about the Fidelity to $500,000 in capital gain taxes if you to real property initially acquired as bond insurance coverage are married and filing a joint return. replacement property through a 1031 maintained by the Qualified You are required to have owned exchange transaction and then subse- Intermediary to ensure that the and lived in the property as your quently converted to your primary insurance coverage is in force primary residence for at least 24 out residence and sold pursuant to and effect, and that coverage is of the last 60 months. The 24 months Section 121 of the Internal Revenue sufficient for the size and scope need not be consecutive and there are Code. of the 1031 exchange operation. certain exceptions to the 24 month Most institutional Qualified requirement when a change of Other Tax-Deferral and Tax Intermediaries maintain Fidelity employment, health or other unfore- Exclusion Strategies bond insurance coverage limits seen circumstances has occurred. between $20 million to $30 mil- Section 121 is effective for disposi- Charitable Remainder Trusts lion. Request a copy of the tions (sales) of real property held as a (CRTs) permit you to transfer your insurance binder to verify the primary residence after May 7, 1997. highly appreciated property or asset insurance underwriter, the poli- You can complete a 121 exclusion into a trust for the benefit of charities cy limit, and policy term/expira- once every two years. you designate. tion date. Ask for the insurance As a taxpayer, you should careful- The CRT provides you an immedi- agent’s contact information and ly monitor the amount of “built-up” ate income tax deduction for the verify that the Fidelity bond capital gain in your primary resi- donation of a property or asset into insurance information contained dence. You may want to seriously the CRT and allows you to immedi- on the insurance binder is accu- consider selling your primary ately dispose of the property or asset rate, complete and up-to-date. residence before the capital gain without incurring any depreciation tax liability exceeds the $250,000 or recapture or capital gain income tax Invest the Time Up Front $500,000 limitation. liabilities. Capital gain tax liability in excess You can then reinvest the net sales Qualified Intermediaries are of these exclusion limitations will be proceeds into investments providing more than administrators. They taxable. A sale of your primary better cash flow. There are different advise on exchange structures residence will preserve the tax-free types of CRTs, so you should discuss and guidelines for compliance exclusion of the capital gain and will your options with your legal, tax and while controlling proceeds from allow you to acquire another primary financial advisors. the sale and purchase of residence and start all over again. In the past there was significant property. Be sure you choose Special legal, tax and financial discussion regarding Private Annuity your QI with care because of the planning is needed in circumstances Trusts (PATs); however, the IRS effec- important role they play. where you already have a significant tively eliminated PATs as a tax-defer- capital gain tax liability in excess of ral option in late 2006.
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