Real estate agents play a significant role during the course of a real estate transaction. That includes the advisory role played by agents involved with investment and commercial property transactions. Real estate sellers of those types of properties make investment decisions based on many factors which include financial considerations such as taxation. One tax avoidance tool is to complete a 1031 exchange.
A 1031 exchange allows a seller of real estate to defer the payment of taxes which would otherwise be due upon selling property. The tax deferral occurs when the seller acquires new property to replace the property that was sold. As long as the proper procedures are followed, the Internal Revenue Service will recognize the transaction, not as a sale and a purchase, but as an exchange of a relinquished property for a replacement property thereby allowing the seller to "roll" any taxable gain into the new property.
Although, the real estate agent's role doesn't change in any significant fashion when the agent's client is completing an exchange versus a non-exchange transaction, it is key for the real estate agent to have some knowledge of the when an exchange is beneficial for a client. That knowledge should include some 1031 exchange basics, particularly of the exchange process, in order for that agent to be a valuable advisor to their client.
1031 EXCHANGE PROCESS FOR A TYPICAL FORWARD EXCHANGE (Reverse exchanges are structured differently)
The point in time when the real estate agent can be the most valuable to a seller of investment or commercial real estate is at the initial meeting with the client. Many sellers, even sophisticated investors, tend to put off considering the tax consequences of a sale. A reminder by the agent to consider the tax consequences of a sale may allow the seller the time to do quality tax planning and may save the seller money in taxes. For liability reasons the agent should not give tax advice. The seller should be steered to their tax professional. The seller may also contact the exchange company at this stage to discuss some of the procedural steps in completing an exchange.
The exchange company plays the role of the qualified intermediary, as required by the Internal Revenue Code (tax code). The intermediary facilitates the exchange and will hold the proceeds from the sale to avoid receipt of those proceeds by the exchanger. Avoiding receipt of the proceeds from the relinquished property is the key aspect of an exchange's tax deferral.
Relinquished Property Listing Agreement
The listing agreement does not need to be altered when a seller is looking at commencing an exchange.
Offer to Purchase Agreement
For the most part, the offer to purchase agreement will not be altered by the seller's exchange. Placing some language in the offer referencing the seller's exchange is recommended. This is done to make the buyer aware of the exchange and aware that an exchange coompany will be involved on the seller's side of the transaction. This wording can also comfort the buyer by stating that the seller's exchange will not cause the buyer any additional cost or liability. Some possible language for the purchase agreement may read as:
Buyer acknowledges that Seller intends to complete a 1031 tax-deferred exchange, and that Seller's rights and obligations under this agreement may be assigned to an intermediary for the purpose of facilitating that exchange. Seller's exchange shall not impose additional cost or liability to the Buyer and Buyer agrees to cooperate with Seller's exchange and execute such documents as Seller may reasonably request.
The exchange is commenced at the closing of the relinquished property and there are some critical requirements at this stage. The exchange company will work with the title closer to coordinate signing the exchange paperwork. Additionally, the closing statement will be drafted to reflect the seller's exchange showing the involvement of the exchange company and delivery of proceeds funds to that exchange company. If the exchange is not set up upon the relinquished property closing and the seller takes receipt of the proceeds from the closing, an exchange will not be possible. The deed will reflect the names of the seller and buyer as it normally would with any transaction.
Once the relinquished property sale closes, the exchanger has 45 days to identify the replacement property(ies) by providing the exchange company with a written description of the replacement property. The exchanger must close on the replacement property within 180 days of the relinquished property closing or less if the due date of the exchanger's tax return falls within the 180 days, unless the exchanger files a tax return extension.
Below is some suggested language for the exchanger's replacement property purchase agreement to make the seller aware of the exchange. The purchase agreement may also require a contingency if the exchanger needs the relinquished property to sell in order to go through with a particular purchase. The rest of the purchase agreement will read as usual.
Seller acknowledges that buyer intends to complete a 1031 tax-deferred exchange, and that Buyer's rights and obligations under this agreement may be assigned to an intermediary for the purpose of facilitating that exchange. Buyer's exchange shall not impose additional cost or liability to the Seller and Seller agrees to cooperate with Buyer's exchange and execute such documents as Buyer may reasonably request.
As with the relinquished property, the replacement property closing statement will reflect the exchange and the exchange company's involvement with the transaction. There are a couple exchange documents to be executed at closing which can be coordinated with the title closer and the exchange company. The deed will reflect the names of the seller and buyer as usual.
When an agent's client is competing an exchange, the agent can be a valuable advisor to the client and reap some benefits themselves. The upside to exchanges for real estate agents are 1) sellers may be able to do a sale that they otherwise would not have been able to complete since funds that would have been paid as taxes are available to reinvest in other property and 2) there will be two transactions since the exchanger is selling and buying property.