Today, many real estate investors are considering tax-free exchanges as a method of deferring taxes on the sale of investment property. With the increasing popularity of tax-free exchanges, the Realtor should be well versed in the technical requirements of a tax-free exchange. Although the investor will often be represented by an attorney, accountant, or exchange service, it is the Realtor who will be encumbered with the responsibility of attending the various closings with the investor, assisting with identifying new investment properties, locating a knowledgeable lender willing to cooperate in such a venture, and generally assisting the investor in completing the exchange.

This article is not intended to inundate the Realtor with an exhaustive study of the comprehensive requirements of a tax-free exchange nor to provide a sweeping analysis of the benefits of an exchange. Instead, this article will briefly address the broad requirements of an exchange while undertaking an intensive study of the Realtor's role in assisting a client through a successful tax-free exchange. The Realtor should be cautioned, however, not to undertake the responsibility of representing and advising the client regarding the tax ramifications and legal requirements of the exchange. Rather, the Realtor should advise the investor to retain an experienced attorney or accountant, lest the Realtor be responsible if the client is denied the beneficial tax treatment of an exchange because of a flaw in consummating the transaction.

Overview of a tax-free exchange

Under Section 1031 of the Internal Revenue Code of 1986, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of a like-kind which is to be held either for productive use in a trade or business or for investment. However, Section 1031, provides certain minimal requirements which must be satisfied for a successful exchange.

First, the initial property to be sold must be held for business or investment purposes. Although the intention of the owner is the dispositive factor in determining a property's use, it is clear that a property presently utilized as a personal residence will not qualify. Further, if the property is held for investment purposes it will not quality if the property is held primarily for sale, such as that of a builder or developer who owns many lots in a subdivision.

Next, the property to be received in an exchange must be of a "like-kind". This means the properties must be similar in nature, although not necessarily in quality. An unimproved lot may be exchanged for a rental building, as they are both real estate, albeit of a different quality. However, the unimproved lot cannot be exchanged for rare gold coins, as these investments are of a different character. Additionally, the exchange must include tangible property, thereby eliminating from the program the exchange of stocks, bonds, notes, interests in a partnership or other securities. The property to be acquired in the exchange must be "identified" as the property to be exchanged on or before the day which is 45 days after the day on which the investor settles on the sale of the original investment property. The investor must then settle on the acquisition of the new property before the earlier of 18 days after the date on which the investor settles on the original investment property, or the due date for the investor's tax return for the taxable year in which the settlement on the original investment property occurs.

Although there are an infinite number of combinations of transactions which may ultimately qualify as a tax-free exchange, including simultaneous exchanges, three-party exchanges and four-party exchanges, this article will address the typical non-simultaneous, delayed or "Starker" exchange. The delayed non-simultaneous exchange is often referred to as a "Starker" exchange following a series of federal court cases decided between 1975 and 1979, including the case of Starker v. United States, wherein the federal court recognized and ultimately sanctioned the use of a non-simultaneous or delayed exchange.

In accomplishing a non-simultaneous or delayed exchange through a series of transactions, the client may first locate the new investment property which he or she wishes to acquire. The client will then sell property presently owned, but arranges for his buyer to instead acquire the new investment property and then to exchange the new investment property with the client for the client's presently owned property.

Although this series of transactions may seem confusing at first glance, in actuality it is not too complicated. The true dilemma, however, is locating a
prospective purchaser willing to cooperate in such a transaction. Because those
unschooled in the mechanics of a tax-free exchange may be suspicious of the entire proceeding the most common method of effectuating an exchange involves the use of a facilitator or trustee to assist the investor. It is in this situation that the Realtor is likely to have the most involvement.

Of great importance is the requirement that the trustee (who is acting on behalf of the original purchaser of the original investment property) must hold the proceeds from the sale of the original investment property in an escrow account. The investor will then, within the time periods set forth above, identify the new investment property. The trustee will execute the contract of sale on behalf of the purchaser in order to obtain the identified exchange property at closing, either the trustee will direct the settlement attorney to convey title to the property directly to the investor from the seller thereof, or title will transfer from the seller to the trustee and then from the trustee to the investor, thereby completing the exchange. The funds held in escrow, together with additional funds supplied by the investor either in cash or from a lender, will be utilized to acquire the new investment property.

There are many steps involved in completing the exchange through a trustee. Summarized below is an outline of the Realtor's responsibilities in assisting the client to a successful exchange.

The Realtor's role in a tax-free exchange

Whenever the client is an investor who is selling qualified property, the Realtor must be certain to suggest to the client the possibility of a tax-free exchange. The Realtor should also recommend that the client seek additional guidance from a skilled practitioner such as an attorney or accountant. The areas where the involvement of a Realtor are required will include the following:

1. Listing agreement. The listing agreement and the multiple listing service entry should reference the fact that the sale of the original investment property is an integral part of a tax-free exchange and the sale will require the buyer's cooperation. Although such reference is not a clearly mandatory pre-requisite to successfully completing an exchange, the exact requirements imposed by the Internal Revenue Service are often difficult to ascertain. However, when it is clear from the outset that a tax-free exchange is contemplated, and the investor acts accordingly, the Internal Revenue Service is likely to look more favorably upon the transaction.

2. Contract of sale. The contract of sale for the original investment property must include language which expressly states that the sale is an integral part of an Internal Revenue Code, Section 1031, tax-free exchange. The provision should also provide that the proceeds from the sale must not be delivered to the seller (investor) but rather should be disbursed in accordance with the written instructions from the trustee and held in the escrow account designated by the trustee. The purchaser may require language in the contract whereby the seller agrees to hold the purchaser harmless and indemnified from any causes of action or liabilities arising out of the purchaser's participation in the exchange and that the purchaser shall not be responsible for any additional costs or expenses. Finally, language should be included in the contract by which the seller represents that he or she has received independent professional advice regarding the tax-free exchange and is not relying on the Realtor(s) for advice regarding the same.

3. Closing on the original investment property. Depending upon how the trustee arranges the transaction, it is possible that the deed of conveyance will name the trustee as a grantee and/or grantor therein. It is also essential that there be a professional review of the deed in order to ensure that it is properly drafted. It is possible that the trustee will prepare the necessary deed(s) and affidavit(s) in advance. In that regard, the Realtor should keep the trustee properly and timely informed of the time, date and location of settlement.

The Realtor should also be careful to ensure that the proceeds of the sale are not delivered to the seller at closing. As a matter of routine, the settlement attorney or title company may, without realizing the jeopardy he or she may be placing on the exchange and ultimately the seller, deliver the proceeds of the sale to the seller, thereby impairing and possibly destroying the entire exchange. Again, as referenced in the original contract of sale, the proceeds must be delivered to the trustee in accordance with the written instructions from the trustee.

4. Identifying the new exchange property. At this point in the transaction, if the investor has not already identified a new investment property to purchase, this will be the Realtor's most important enterprise. The investor will have 45 days from the date of closing on the original investment property to identify the property to be received in the exchange. The identification of the exchange property is likely to be a two-step process. Initially, the investor will notify the trustee, in writing, of the designated exchange property. The trustee, on behalf of the purchaser, will then execute the contract offer (on a contract to be completed by the Realtor and/or the investor) and the contract offer will be presented to the seller of the exchange property. The contract must also include language stating that the purchase of the subject property is an integral part of a tax-free exchange. Language should also be included explaining why the trustee is executing the contract on behalf of the ultimate title holder (the investor) and that the investor is solely liable for all obligations arising out of the contract of sale. In this transaction, the seller of the exchange property may require language wherein the investor holds the seller harmless and indemnified from any liability, costs, or expenses arising out of the seller's participation, if any, in the exchange. Finally, depending upon the method of completing the exchange utilized by the trustee, the contract should state that either a three-party deed wherein the trustee is a grantor therein, or two deeds will be utilized. In some instances, the trustee will instruct the seller of the new investment property to convey the same directly to the investor In any event, the proper instructions should be included in the contract.

In light of the increasing demand for properties in the Washington metropolitan area, along with the limited supply of properties, the Realtor should give the trustee sufficient advance notice that a property identification is forthcoming. Any delay in obtaining the trustee's signature and the necessary addendum may cause the sale to be lost.

In some instances, the prospective properties may be lost because the
seller may be intimidated by or fearful of participating in an exchange. In
view of this possibility, the Realtor should be prepared to assist the investor in locating several alternative choices for an exchange property. Once the exchange property is properly identified, arrangements must be made for closing on the new investment property.

5. Closing on the new investment property. Closing on the new investment property must be completed within the earlier of 180 days after the sale of the original investment property or by the due date for the investor's tax return for the year in which the sale of the original property took place. It is unlikely that closing within the required time period will be a problem. However, once again, the trustee should be kept apprised of the time, date and location of the closing. In most cases, the trustee will maintain constant contact with the settlement attorney. However, because the deed(s) of conveyance will have to be prepared and perhaps executed in advance, a proper amount of advance notification to the trustee will help to avoid any unnecessary last minute obstacles or postponements. Once settlement on the new investment property has concluded smoothly, the Realtor's role in the exchange will be complete.

In light of the many parties who will be involved in an exchange, in the likelihood that the investor will not be a seasoned tax-free exchange veteran, it is critical that the Realtor constantly works to keep all parties notified as to the many events described above. In a tax-free exchange, communication may be the Realtor's most important service. The inability to properly satisfy one of the technical requirements of Section 1031, if caused by the failure to properly communicate with the appropriate party, may expose the Realtor to liability. Although the Realtor, as agent for the seller, owes the highest standard of loyalty and care to the Realtor's principal, the seller, the Realtor must still exercise due care and good judgment when working with an investor/purchaser on a tax-free exchange.

Finally, not only will the investor receive the beneficial tax treatment available under Section 1031 of the Internal Revenue Code, but there exists one additional yet to be described benefit of an exchange--for the Realtor. If handled properly, the Realtor not only will obtain the listing on the original investment property, but the Realtor may also earn a commission as the selling agent on the new exchange property! However, as emphasized from the outset, there are many technical requirements for complying with Section 1031, and although the Realtor will play an active role in a tax-free exchange, the first and foremost responsibility of the Realtor is to suggest that the investor seek the advice of an independent attorney and/or accountant.