[Note: To follow is an excerpt of an interview with Michael A. Anderson, CES, Certified Exchange Specialist. Michael is president of Exchange Services, LLC, an affiliate of Zions Bank that serves the QI needs of the affiliate banks and national customer base. To listen to the show archive or download an MP3, go to www.IncomePropertyInvestmentTalk.com/052009.]
Mosca: Section 1031 of the Internal Revenue Code provides a series of different things for different types of investors. What is a 1031 tax-deferred exchange as it relates to the real estate investment and why is it so valuable?
Anderson: The point of owning real estate is to have it appreciate in value and if you want to change that or sell that property, you may have a substantial tax liability as a result through capital gains taxes, both state and federal. Section 1031 allows you to exchange one investment property for another and doing so appropriately defers the capital gains tax that might be due in such a transaction if it were a sale. As you near closing for the sale of your investment property, you have to decide whether to do an exchange or not before you actually close on your sale. As you near that point, you decide to call a qualified intermediary or QI like myself or any of my colleagues in the business and the QI will set up some documents for you which will convert your sale into an exchange. What that does is it transfers typically the right to receive the proceeds of the sale to the qualified intermediary, so when the sale closes the funds go to the QI to hold them for you while you go look for your replacement property. You have to acquire or identify your short list of replacement properties within 45 days of the sale and you have to actually close those properties you want to acquire within 180 days of the sale or the due date of the tax return for the year in which the sale took place including extension. Planning ahead always helps in life and this is another situation where planning ahead helps you avoid heartburn at the last moment.
Mosca: What separates or makes Zions Bank or your Exchange Services, LLC different or unique from the typical exchange provider?
Anderson: At Exchange Services, we use the qualified trust model, which means that we don't own the funds. Typically the QIs in the past have used the safe harbor where the QI gets to own the funds in between and they get to do with it whatever they want in general. Under the qualified trust model, we create a trust for the taxpayer and the funds belong to the taxpayer but are restricted from their access according to the safe harbor for the qualified trust by means of the trust. We also invest the funds in separate bank accounts, which have the benefit of FDIC insurance.
Mosca: As an example, I am one investor of maybe 17 who has invested in a tenant in common property and that property is going to sell in September. I want to invest the gain again in another income property. What is the process from there?
Anderson: Basically what we do is compare some documentation to convert your sale to an exchange. Then, at the closing, the funds come to us and we hold them in a qualified trust account for your benefit while you go look for new property and you have up to 45 days to identify your short list and then you have up to 180 days to actually close on your replacement property.
Mosca: Another example, I am investor and I feel it does not make sense to exchange today with the way the market is and it is better to just pay the taxes. What do you say about that?
Anderson: Whenever you pay the tax, the tax money is gone and it is really hard to make up that loss from a return basis. Some people are saying tax rates may go up and there is a good chance that they will. We have even done some modeling here and it turns out that even if rates go up say to 35 or 39%; it's hard to catch up once you pay that big chunk of capital gains tax. It doesn't mean you shouldn't do it in certain situations but it's just giving yourself a handicap that's hard to catch up with. A 1031 is a good way for people to create flexibility in their investor plans as they decide to go from one type of investment, say your duplex or into a TIC or other sort of vehicle. It's a great way to do so without being penalized.
Mosca: One of the overriding themes of this program is the importance of relationships with experts in this business to success. Do you agree?
Anderson: This past weekend, I was at a conference of people in our industry -- the Federation of Exchange Accommodators. We review there and talk to each other about what we are doing and about new authority and regulations and decisions on related parties and vacation homes and partnership return questions and it's a fun time to get together and talk shop and catch up on things. It is important to look for people who have those professional qualifications and in our industry it for the Certified Exchange Specialist. I would encourage people to look for professionals as you say that are qualified and have made commitment to the industry.
Mosca: Mike, we are now in a global economy. Does the law apply to foreign properties?
Anderson: Generally, you can exchange domestic properties for domestic properties and foreign properties for foreign properties.
Mosca: Is there any discussion to change that or do you think it's always going to stay domestic to domestic and foreign to foreign?
Anderson: It's hard to know what Congress is going to do at any given time. There has not been as much pressure on that as there has been on other issues.
Mosca: What are some of the other issues coming up in the months or years ahead?
Anderson: There is concern about folks who are unwittingly involved as customers in failures and offering some sort of relief for them, especially those that lost a lot of money in capital and had to pay 'boot.' I'd like to see some support for those folks, but I don't know what hope there is for that. Boot is income that is subject to tax; the tax liability is called boot in an exchange.
Mosca: Can you talk about some of the different ways to protect customer funds?
Anderson: Certainly. Some problems came as a result of honest mistakes and not necessarily unscrupulous activities. It happens either way. The most important thing is to understand who is holding your money, who they are, what their qualifications are, what their management strategy is, and what they're holding strategy is. For example, there are three safe harbors the IRS allows for this kind of a procedure. One is the qualified intermediary, one the qualified trust, and the other, the qualified escrow. The qualified intermediary approach has been more common. Basically the qualified intermediary receives the funds and they are the qualified intermediary's funds in the interim. The qualified intermediary can go invest those funds and if they pay that taxpayer 2% and they can make 4% or 5%, they keep the difference. Under the qualified escrow, qualified trust model the funds belonged to the taxpayer and are just held in escrow or in trust for the taxpayer. Again, in a situation where there is a bankruptcy or some question about who the funds belonged to, the qualified trust or the qualified escrow models are much clearer legally belonging to the taxpayer then the qualified intermediary approach. Most of the qualified intermediaries are very honest, very straightforward. It's an actual layer of protection we give to our customers. We do not put them in pooled accounts. We put every single taxpayer in a different, separate bank account. Plus, we pay all the interest to the taxpayer.
Mosca: What is your golden nugget for today?
Anderson: Even though the economy has had some turbulence recently, don't lose heart, look forward, be careful, think things through, don't throw away your money needlessly, make good decisions, analyze, underwrite, ask questions, and we will all make it through this.
P. Mosca
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