Commercial real estate brokers and mortgage brokers who overlook opportunities to suggest 1031 exchanges to their clients are missing out on additional commissions.
The Internal Revenue Service Code Section 1031 allows a property seller to defer capital gains tax from a property sale by rolling the proceeds into another investment property. Why would an investor want to complete a 1031 exchange? And how does the real estate or mortgage broker stand to benefit?
The examples that follow show the rewards that can flow to all parties in exchange transactions, including buyers, sellers and professionals who earn commissions. We'll explore three scenarios: optimization, multiplication and replication.
Joe Jones purchased a piece of real estate for $100,000 and is now selling it for $500,000. He stands to make a $400,000 profit, which, taxed at 15 percent for capital gains purposes, would trigger a $60,000 tax bill, leaving Joe with $340,000 for a down payment on another property. But if Joe does a 1031 exchange, he can keep the entire $400,000 and acquire real estate worth $1.6 million$40,000 down and 75 percent financing on $1.2 million.
The broker involved will earn a higher commission on the $1.6 million exchange transaction than on a lower-cost purchase. The resulting optimization of wealth will certainly please most investors.
Rather than trade the original property for a single larger one, Joe Jones could also purchase four real estate properties valued at $400,000 each. As Joe multiplies the number of properties that replace the original one, he spreads out his liabilities.
Joe is happy with that outcome, and his broker has turned a single commission into four. The broker has also had an opportunity to meet additional clientsup to four sellerswho may need his services and expertise.
Consider the transaction involving Martha Smith, who is purchasing a new property. An alert broker will contact all of the parties in this transaction and explore the possibility of additional 1031 exchanges. This includes the seller from whom Martha is buying the property, who we'll call Mrs. Green.
What plans does Mrs. Green have for the funds she is about to receive? If she plans to reinvest in real estate, perhaps Mrs. Green should consider completing a 1031 exchange. Given the advantages previously outlined under optimization, she might indeed be grateful to learn about 1031 exchanges.
For the well-informed broker who reaches out to buyers and sellers in this context, commissions are there for the asking.
Imagine that you are the broker in the following real-life example of one investor who used optimization, multiplication and replication. He has paid virtually no capital gains tax on his real property investments. He started with two $3,000 lots. Today, his net worth is more than $2 million.
In 1975, a real estate agent friend introduced me to an enlisted manwe'll call him Jackwhom I represented in a 1031 exchange. During leave from the Marine Corps in San Diego, Jack worked as a croupier in Las Vegas, where he saw a vacant lot listed at $3,000. He put down 300 hard-earned dollars, and the seller agreed to finance the $2,700 balance. The next year, Jack took the same trip to Las Vegas, visited his lot and found the neighboring one for sale: same seller, same price and terms. So, he bought the second lot too.
In 1988, Jack was offered $30,000 each for his Las Vegas lots. He proudly told our mutual friend, the real estate agent, that he would soon have $60,000 to invest in other real estate. The real estate agent gave Jack the bad news that he would owe approximately $15,000 in capital gains taxes if he sold the lots outright. But the real estate agent saved the day by suggesting that Jack consider doing a 1031 tax deferred exchange.
The real estate agent found Jack two duplexes at $30,000 each, plus received two commissions on the deal. Jack later refinanced his duplexes for $42,000. With the $40,000 cash left after closing costs, he purchased a $225,000 warehouseanother broker commission received.
In 1989, he refinanced the warehouse, by then worth $450,000, to receive $115,000 in cash for the down payment on a $350,000 single-family residence. Again, this produced additional broker commissions.
In 1999, he exchanged the warehouse for a small office building in Hawaii, once again deferring all taxes on his gains. Yet again, this produced additional broker commissions. In 2000, Jack eventually sold his home for $875,000. He applied the Internal Revenue Code Section 121, which allows a $500,000 per-couple exemption. Hence, his taxes on the residential sale were a mere $3,750.
Jack still owns the two duplexes, now valued at $100,000 each. His net worth is more than $2 million, yet if he were to die today, his estate would owe no taxes. Not bad for someone whose real estate holdings began with a pair of $3,000 lots, each purchased for only $300 down.
Brokers who help clients explore property exchanges are helping principals grow their holdings while creating legitimate opportunities to earn multiple commissions themselves. That's how optimization, multiplication and replication can work. By simply introducing clients to 1031, everyone benefits.
This article should not be considered tax, accounting or legal advice. Readers are urged to seek advice from their accounting or legal professional before taking action.
Stephen A. Wayner Esq., CEA is vice president of Bayview Financial Exchange Services LLC. He may be reached at (305) 644-4631 or e-mail [email protected]