Trading Places: The Growing Business of Exchanges

May 1, 1996

The exchange business is hot. So says exchange expert William Townsend, vice president of Starker Services Inc., Bellevue, Wash., a company that facilitates like-kind, or 1031, exchanges.

"I'd say the business is growing exponentially," says Townsend, who has expanded his business into the Midwest and the South since the Internal Revenue Service finalized its 1031 exchange rules in 1991.

How the business fares in 1996 will depend on two things: interest rates ("They've got to stay low," Townsend says) and the capital gains tax debate. "Right now, we have a lot of fence-sitters who, if the capital gains tax rate drops, will get out of real estate rather than exchange," he says. Townsend's betting that's not going to happen.

A lively exchange market isn't good just for Townsend and his ilk. It's good for you, too. And if you're wondering how, read on about how two practitioners successfully used the tax code's 1031 rules to help buyers make a prudent property trade.

Schooled in Exchanges, Salesperson Makes the Grade

Craig Roberts, a salesperson with Prudential Bentons Realty, Seattle, was helping Darwin and Christine Chevalier find a larger facility to house their private school, the Perkins School for Children. They found a property, but the $735,000 price tag was out of their budget range.

Roberts set about to help the Chevaliers raise additional capital.

Christine's parents, W.E. and Betty Lea, owned some rental property. The property's tax basis was very low, so if they sold the property to help the Chevaliers buy the school, they'd face a large capital gains tax. Instead, Roberts recommended a 1031 tax-deferred exchange.

The rental property was turned over to an exchange intermediary, and using the cash proceeds from its sale, the Leas bought an undivided interest in the new facility, along with their daughter and son-in-law.

The Leas' exchange, a sole ownership in rental property for an undivided interest in commercial property, qualified as a like-kind-property exchange. The Chevaliers got a new home for the Perkins School.

The Leas got to defer all taxes on the sale of their rental property, and their daughter and son-in-law pay them rent on their share of the building. They're now getting a better return than they got on their old investment property. And Roberts earned a commission on the sale of both the school facility and the Leas' rental property.

Turning an Investment Property Into a New Business Site

Dennis Lindsay operates Lindsay Moving & Rigging, a heavy-equipment company that in 1995 was quickly outgrowing its site.

The company's options were few. Moving the entire business to a new site would have been expensive and time-consuming. Lindsay would have had to sell the company's present site and find an area with proper zoning and business access. An adjacent parcel was rumored to be going on the market soon, but how could Lindsay raise the cash?

Sabine Bestier, a salesperson with John L Scott, Kirkland, Wash., represented Lindsay. She learned that Lindsay had several other investment properties in the area. With Bestier's help, Lindsay is now in the process of exchanging one of his investment properties (he decided to keep the others) for the adjacent site. For her innovative approach, Bestier will be well rewarded. She'll get commissions on the sale of Lindsay's investment property and on the purchase of the adjacent land.

Lindsay's company also gains from the exchange. It has room to expand, and its operating cash reserves are still in place, since they aren't needed to complete the transaction. The equity in the original investment property was adequate to secure a new loan.

You, Too, Can Make Valuable Trades

You don't have to specialize in exchanges to make money from them.

If you have clients who'd benefit from a 1031 exchange, you just need to find a qualified intermediary to make it happen.

William Townsend, vice president of Starker Services Inc., Bellevue, Wash., served as intermediary for the two salespeople whose stories are told in "Trading Places." We asked Townsend to answer a few common questions about exchanges.

An exchange isn't a sale---so how do I make money?

An exchange is a sale---two sales, actually. Section 1031 of the tax code allows taxpayers to sell a property and acquire a replacement property anywhere in the United States and defer capital gains tax. So when you represent someone in an exchange, you often earn two commissions instead of one. Sellers need to use a qualified intermediary and follow the other rules laid out in the code.

Other rules? Such as . . .?

Sellers need to identify replacement property within 45 days of selling, and they need to receive the replacement property within 180 days of selling or by the date they file their tax return. (So if they haven't replaced the property and the 180 days aren't up on April 15, they should file for an extension.) Otherwise, they'll need to pay the capital gains tax.

When sellers identify replacement property, they can list up to three properties, and the properties don't need to be secured by a purchase agreement.

Then there's the 200 percent rule: If you want to identify more than three replacement properties, the fair market value of all the properties can't exceed 200 percent of the fair market value of the property you left.

What kind of property qualifies as a replacement?

Virtually any property where you don't live. Sellers can exchange a shopping center for land, or an apartment building for an office building. Second homes and vacation homes fall in a gray area depending on how many days during the year the owners use them.

How do sellers find a replacement property?

That's where the real estate practitioner comes in. Intermediaries can't act as agents and maintain their qualified intermediary status, so my company has an informal networking system with salespeople. Let's say, I get a call from an apartment owner here in Bellevue who's retiring and moving to Florida. He doesn't want to manage his apartment building from Florida, so working with salespeople here and in Florida, I can help him trade it for a comparable Florida investment property.

What happens if Congress ever does away with the capital gains tax?

A very important tax strategy will be lost to real estate investors---and I'll be looking for new work.

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