New tax rules for 1031 exchanges may make the business side of these transactions more transparent but may not have much bottom-line effect on investors. The most important thing they will do, industry observers and participants said, is put aside 10 years of controversy and uncertainty—a welcome change.
In a 1031 exchange, investment owners are allowed to put off paying capital gains taxes on sale of a property or business by reinvesting sale proceeds in a “like kind” of property. For example, U.S. real estate held for investment purposes can be exchanged for other U.S. real estate, foreign property for other foreign property, or one business interest for another that meets certain rules. In some cases, even a vacation home can qualify.
Most 1031 exchanges are carried out with the help of a “qualified intermediary” (QI) who parks the sale proceeds, or “exchange proceeds,” in an escrow or trust account until the replacement property is purchased. The new rules cover who pays taxes on earnings in accounts held on the investor’s behalf during the time it takes to complete the exchange.
New rules may lower fees paid to intermediaries in the exchange
Some QIs keep exchange proceeds in separate accounts or sub-accounts under the property owner’s name and tax identification number. All earnings on the proceeds held in these accounts during the transaction are attributed and paid to the owner. Other QIs keep clients’ funds in aggregate accounts; some pay all the earnings (generally, interest or dividends) to the property owner, but others keep all or a portion of the earnings as part of their compensation for facilitating the deal. Some industry experts say this helps keep fees paid to QIs for their services down.
Under the new rules, starting Oct. 8, 2008, the IRS will treat exchange proceeds in excess of $2 million as loans from the property owner to the QI. The same treatment will be applied to exchange proceeds held in an escrow or trust account for more than six months. In either case, if the property owner receives earnings on this money at a rate that is less than the interest paid on a 13-week Treasury bill, it will be treated as a below-market loan. That means the property owner will have to pay taxes on the interest even if the QI retains some of the earnings.
Controversy dispelled in final rules
During the nearly 10 years of deliberations over how earnings on exchange proceeds should be taxed, the IRS received comments from many representatives of the QI industry. Representatives of exchange facilitators owned by banks and title insurance companies, among others, argued that property owners engaging in 1031 exchanges were not always aware or apprised of how much their QIs were earning on the proceeds held during the transaction.
Owners of smaller, mom-and-pop QIs, which provide services mostly to investors engaging in smaller transactions, noted that finance industry-owned intermediaries receive other kinds of compensation from their parent companies for bringing in business and don’t rely on interest earned from exchange proceeds as part of their income. They argued that earlier tax proposals would have given a big competitive advantage to bank-owned QIs.
In issuing the final rules, the IRS avoided further industry controversy by exempting transactions involving exchange proceeds of $2 million or less from the below-market loan provision. According to Mary Foster, president of the Federation of Exchange Accommodators, a QI industry trade organization, the industry is pleased with the result. “The IRS listened to comments on the proposals and changed the rules so they are fair,” said Foster, who is president of 1031 Services, Inc., a Bellevue, Wash.-based QI.
Improved clarity regarding escrow taxation is one benefit of the new rules
Mary Cunningham, president of Chicago Deferred Exchange Co. said the most important thing about the new IRS rules is that “there’s certainly clarity now” on how escrow earnings will be taxed. Cunningham said she hopes that settling the tax issue will make the industry more transparent even for transactions of $2 million or less. “The investor always wants to ask questions of the QI—‘How is the money is being invested? Who gets the benefit?' If you have $1 million sitting in an account for 90 days, you want to get the interest on it,” she said.
In discussing the controversy over the proposed rules, Cunningham said it was “a consumer rights issue. The taxpayer should be earning interest on his money. Many taxpayers were giving up income and perhaps not being aware of it. In this interest rate environment, it may not make much difference. But a few years ago when the rate was higher, it could have made a difference.”
The bottom line
With interest rates expected to rise, the new rules could have more of an effect on investors in the future. Foster, the FEA president, said the IRS decision will force property owners making larger transfers to use intermediaries who keep escrowed client funds in separate accounts, and “this is as it should be.”
Eric W. Odum, a real estate adviser with Florida Triple Net Properties, which helps clients obtain replacement properties for 1031 exchanges, said that about 80 percent of all like-kind exchanges are below the $2 million threshold. While these smaller transactions won’t be directly affected by the new rules, they are affected by the exemption for transactions involving $2 million or less.
The biggest effect will be felt if the industry responds as Cunningham hopes. “It might make the market respond” by forcing all qualified intermediaries to be more open about how they do business, she said.
