A successful exchange, from the standpoint of qualifying for a IRS approved tax deferment, requires some careful planning. Generally speaking, there are four kinds of exchanges:
- Simultaneous exchange meaning that the "down-leg" and "up-leg" properties close escrow at the same time.
- The delayed exchange, which is usually referred to as the "Starker" exchange. The rules require the exchanger to identify the up-leg property within 45 days from the close of escrow of the down-leg property and the up-leg property must close within 180 days from the original close of escrow.
- The reverse exchange which occurs when the up-leg property is acquired before the down-leg escrow closes. This case also require special handling and the rules are similar to the "Starker" exchange except that there are no specific time limits with regard to the escrow closing dates.
- The Construction exchange when the up-leg property is not completely ready for occupancy when the down leg property escrow closes. This type of exchange can be either simultaneous, delayed or reverse.
Other than the IRS imposed time limits, there are other potential problems in doing an exchange:
- Both the down-leg and up-leg properties must be "like-kind" properties, which includes the manner in which title is held.
- The amount of net equity held in the down-leg property must be transferred to the up-leg property or else tax liabilities can be imposed.
- The amount of bebt owed at the time of closing on the down-leg property must be the same, or more, on the up-leg property or tax liabilities can be imposed.
Assuming that the above hurdles are handled there are still some major problems topics to be considered:
- Cash Flow. Will the up-leg property produce the same net after-tax income is the down-leg? Often there is a period of time when you must accept less income because of deferred maintenance to be cured, tenants to be replaced, un-foreseen expenses are absorbed or other financially related surprises are encountered:Increased Risk. Exchanging into a property that has different operational requirements that the new owner may be familiar with, can increase investment risk. The time required to manage elements of the new property may increase, or environmental issues may change, or demographic changes may occur that were not foreseen.
- Shifting Market Changes. The timing of buying and selling property is universally recognized as a big factor in realizing financial gains. What is often overlooked is the fact of that there are times that the apartment house market may be on the incline while office buildings may be on the decline. Exchanging from a type of property that is on the incline for one which is losing popularity for investors, and is on the decline, may work to the financial disadvantage of the exchanger. What advantage that is gained by deferring taxes on the down-leg may be lost entirely by exchanging to a type of property that is on the decline. Sometimes these shifting market trends are difficult to foresee.
- Representation. Choosing those who will assist you in completing your exchange may prove to be among the most crucial decisions you will make. It is very common to assume that all attorneys and accountants are equal in dispensing quality advice. Nothing could be further from the truth. Here are some factors to consider: The attorney you chose may be well versed in the law, but may have less transactional experience than the client seeking advice. The attorney who owns no income property, or very little, may not be the attorney whose advise is to be blindly followed. If you were to ask your CPA how many properties he owns, if the income producing type you might be shocked to learn that he owns none! The problem in choosing CPAs, and attorneys, is that they tend to blend business advice into their tax and legal advice for which they may have less experience that the client they advise.Even more that the quality of the attorney and CPA that you chose is the quality of broker you settle on. The turnover in real estate agents is enormous. Even the newest rooky will be able to speak with conviction and sound like an expert. There are sales training classes available for these inexperienced agents that will make them sound perfectly competent, even though they have no, or very little, experience. In choosing an agent it would be wise to find one who has actually closed several exchanges, of the various types, to assist you in completing a qualified exchange that is profitable. Most agents who can survive at least one year selling investment real estate can sound professional, experienced and qualified, and can make a very good impression. After all, making a good impression is the very first skill an agent must learn regardless of his other skills.