exchange how to steps

Investing Fundamentals

How Does One Do An Exchange?

By Shayne Bowen

This is the second in a series of articles on items that are of concern to those who own investment real estate. As an owner of investment properties, I hope that this series of articles may be of interest to you.

This article is the second part of a series I have written on real estate exchanges. You may say, "Why would this be of interest to me?" The answer is that it is wise for investors to be aware of ways to enhance their profits from their investment properties. One important way of doing this is through real estate exchanges. At a minimum, investors should know about the options available to them.

In my first article, I explored what an exchange is, and the many benefits that can come from utilizing this method of selling one's investment property. My first article on the topic of exchanging can be found at ShayneBowen.com/exchangebenfits.htm.

In this second article, we will examine the relatively simple mechanics of how to do an exchange.

For the purposes of this article, I will illustrate each step in the exchange process by utilizing an example of a typical client going through the process. This typical client owns a modest real estate rental property in Santa Rosa, a single family home. This couple, the Hendersons (not their real names), moved out of state to Connecticut several years ago. They kept their home in Santa Rosa as a rental.

The Hendersons are thinking about exchanging for several reasons; the most prominent reasons are: 1) They would like to have their income property closer to them, in order to avoid long-term management issues; and 2) They have located a new, larger real estate investment opportunity where they now live in Connecticut. This new investment will be close to their new home, and will provide them more income and create a modestly higher net worth for them; 3) They do not want to pay taxes right now on the capital gains from selling their Santa Rosa rental. (By not paying capital gains taxes currently, the Hendersons are able to own a more significant investment property, thereby enhancing their rental income and net worth.

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How Does One Do an exchange?

Step 1: Determine If An Exchange Is The Right Thing To Do

The first step in doing an exchange is to determine if the benefits of exchanging fit the investor's goals. (See my first article on exchanging for a detailed look at the benefits of exchanging. This article may be viewed at ShayneBowen.com/exchangebenfits.htm).

The Hendersons were already aware of the ability to defer taxation by doing an exchange. They had long wished to have their investment property closer to them, in Connecticut, and they became aware of a really nice real estate investment opportunity close to them.

They contacted me, and expressed their goals. They told me about having tentatively located a nice 'replacement' investment property, a triplex. This property was near them (in Connecticut), and was a larger property, with more income than their current single family rental in Santa Rosa. They needed to sell their Santa Rosa rental in order to purchase this 'replacement' property, but they didn't want to pay a large capital gains tax bill. Paying this large tax bill now would have made it impossible to purchase the new investment property - there would not have been sufficient funds after the taxes were paid.

The Hendersons were considering purchasing a property that had a modestly higher price than their Santa Rosa rental home, and they were planning on having a loan amount slightly higher than their current loan amount. On my advice, they consulted with their tax advisor, to make sure that an exchange was a good thing for them. Their accountant concurred that the exchange would defer the payment of a large capital gains tax, and would allow them to invest in a quality piece of property located in the Henderson's home state. For exchanges, one must a) purchase a 'replacement' property with an equal or greater price; b) reinvest all the equity - avoid taking any cash out; and c) have a loan amount on the 'replacement' property that is equal or greater to the property that you are selling.

We mutually came to the conclusion that an exchange well suited the accomplishment of these financial goals.

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How Does One Do an exchange?

Step 2: Sell The Currently Owned Property

Step two in the exchange process is to sell your currently owned property.

Placing your current property on the market is simple. For this step, our investors, the Hendersons, phoned me, and let me know that they wanted me to begin the process by placing their current property on the market.

I began the process, and explained that we would state in the MLS (multiple listing service) that their property was 'contingent upon the completion of an exchange.' I explained to them that this language has no practical effect on the transaction, other than to serve as a 'paper trail' for the IRS that the transaction is intended to be an exchange.

I told the Hendersons that the sale process for their current property would proceed just like the sale of any other property, except that we would place language in the purchase agreement stating that the sale of the Hendersons property is part of an exchange. Other than that, I told them that the sale of their current property would involve me doing all of the normal sales-related steps (market analysis, decide on a price, prepare the property for the market, list the property, market the property, negotiate a purchase agreement, solve typical problems encountered during the escrow, and supervise the closing of the property).

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How Does One Do an exchange?

Step 3: Arrange for a Facilitator

Step 3 in the exchange process is to arrange for a facilitator. (Sometimes facilitators are referred to as 'accommodators' or 'intermediaries.') A facilitator offers important services for people completing an exchange.

Facilitators offer several services:

They temporarily hold your net sales proceeds until they are invested in your replacement property. (In an exchange, it's important to not receive any of your sales proceeds from your current rental property.)
They handle the complicated paperwork associated with the tax and title portions of the exchange.
They help with, and retain the paperwork associated with 'identifying' one's 'replacement' property.
They offer incidental tax related advice, as needed, during the exchange (any significant tax advice should come from your personal tax advisor).

In this regard, I mentioned to the Hendersons the names of several well known facilitators. I informed them that the cost of the facilitator generally ranges from about $300.00 to $1,000.00, depending on the scope of services one needs. In this case, the Hendersons already had arranged for a facilitator in their home state of Connecticut, so I took no further action in this regard.

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How Does One Do an exchange?

Step 4: Identify Replacement Property(s)

Step 4 in the exchange process is to 'identify' one's 'replacement' property. The replacement property is the property that is being purchased after one's current property is 'sold.' The facilitator assists in this process, by instructing the investor on the different ways to 'identify' the replacement property. There are at least three methods that may be used for identifying one's replacement property.

I asked the Hendersons to check with their facilitator regarding the methods most often used to 'identify' a replacement property. The Henderson's facilitator recommended that they employ the most frequently used method, which is to locate three properties that they would potentially like to buy.

The Hendersons already had in mind the property that they wished to buy for their replacement property. Nevertheless, their facilitator advised them to locate two other potential replacement properties (for a total of three) in case their primary choice didn't close escrow.

Note that the majority of investors at this point haven't yet identified their potential replacement property(s). This is normal. In order to identify a total of three potential properties, the Henderson's Realtor in Connecticut assisted them in locating the potential replacement properties. (If the client wished to buy a Sonoma or Marin county replacement property, I would have assisted them in locating their three potential replacement properties).

Once the Realtor assisted them in locating three potential replacement properties, the Hendersons 'identified' them by filling out a simple one page form, provided to them by their facilitator. On it they wrote the addresses of the three properties. Note that they didn't (and don't have to) close on all three properties. All they need to do is ensure that the replacement property or properties that they close on are at least the same price as the property they sold, that they have at least the same amount of total equity, and that they have at least the same amount of total loans on them. Once they filled out the paper (usually one page), they faxed it back to their facilitator, who retains it, pending the completion of the exchange.

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How Does One Do an exchange?

Step 5: Purchase The Replacement Property(s)

The fifth step in the exchange process is to purchase and close on one of the replacement properties identified in the previous step. This step has to be completed (normally) within 180 days of the date that your original property closes. (There is an exception to this 180 day time period, depending upon when your original property closes - speak with your tax advisor on this).

In the case of the Hendersons, their Realtor assisted them in creating and obtaining approval of a purchase agreement on one of the properties that they identified (their original choice). Their Realtor then assisted the Hendersons through all of the normal aspects of an escrow (obtaining financing, inspections, monitoring the escrow, providing all necessary documents, and monitoring the closing). The Hendersons notified their facilitator that they were in contract on a replacement property, and notified the facilitator of the projected close date. The facilitator then provided all necessary documents and instructions to the title company. The Hendersons closed on their replacement property approximately 50 days after their original property sold.

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The Hendersons completed an exchange. In essence, an exchange is a relatively simple process, involving the sale of their current property, and the purchase of a replacement property, within the legal and tax framework of an exchange. The benefits are considerable. The Hendersons have accomplished the following:

They deferred paying any taxes on the profits from the sale of their current property.
They sold an out-of-state property (in Santa Rosa) that they had difficulty managing, and located a property close to their current home in Connecticut. This allowed for easier management.
They increased their net worth, by purchasing a modestly larger property than they originally owned (which they were able to do because they didn't have to subtract from their down payment the taxes that they would have otherwise have had to pay).
They increased their rental income by investing in a modestly larger property.
They had the 'best of both worlds' price-wise, by selling their original property in a hot market, and bought the new property in a somewhat depressed market.
They will potentially experience more appreciation in future years, because they own a modestly larger property. (10% future appreciation based upon real estate worth $400,000 is more profitable than 10% future appreciation based upon real estate worth $325,000.)

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How Does One Do an exchange?

Quick Synopsis

Here is a review of the exchange process, from start to finish.

Step 1	Step 2	Step 3	Step 4	Step 5
Is an exchange for me?	Sell the current property.	Obtain facilitator.	Identify property(s).	Buy replacement property.

Tax Advice / Disclaimer

Tax law is complicated, and various circumstances can affect the scenarios listed above. If you are considering utilizing an exchange, or are considering a regular sale of an investment property, it is advisable to consult with a qualified CPA or tax advisor. Request that they run the numbers and provide a personalized tax scenario for you.

The information in the article above is intended as general information, and it's important to not apply this to your individual situation without seeking expert tax advice.

Also, consider calling an exchange expert for your exchange related questions. On such firm (called an intermediary) is Starker Services, Inc. Their telephone number is 800-332-1031. There are many, many other firms that offer this service. To check other firms, do a search at google.com for 'tax intermediary'.

Contact & Biographical Information

If you would like to explore, at no obligation, the sale or exchange of your investment property, please contact me. I may be reached at 707 577-8200, or you may email me at ShayneBowen@yahoo.com. I respond promptly and fully to either type of inquiry.

If you would like to begin the exploration of number scenarios for your Northwest Santa Rosa property, please phone me for the first step, which is a no-obligation, complementary value analysis of your property. This analysis will give you the starting point for the numbers analysis.

I have specialized in real estate sales in the Northwest Santa Rosa area for over 12 years. For a list of the homes that I have personally marketed in Northwest Santa Rosa, please click here.

As a seller of a Northwest Santa Rosa property, you deserve someone with extensive local knowledge. Here are some details on my actual results:

* Over 104 closed sales in Northwest Santa Rosa

* Over $18,000,000 (million) dollars of closed sales in Northwest Santa Rosa

To see my professional resume, click on here.

Investors are a large portion of my clientele. Well over 50% of my clients are investors. I have owned investment property in Northwest Santa Rosa, and out of state. I have access to several vendors who can accomplish many things for an investor during the marketing period of a property, including painting, landscaping, repairs, etc. I obtain these estimates for the investor, because a large majority of investors live out of the area. I handle all of these matters so that the investor does not need to.

I obtain competitive estimates, and present the investor recommendations based upon many, many years of personal and business experience regarding the improvements (if any) that will make the largest net profit for the investor.

I have tremendous experience in knowing how to optimally intersect the seller's need for continuing cash flow from the existing tenant with the important need to maximize the value of the property during the marketing period. I am highly experienced and knowledgeable about various strategies for handling cash flow issues during the marketing and/or preparation for marketing period.

For client professional references, click here.

If you would like to speak with me regarding the first step in the sale (or exchange) process, you may request a complementary, no obligation market analysis of your current property by phoning my office at 707 577-8200.

If you would like a complimentary, personalized property value analysis, please phone Shayne Bowen at 707 577-8200! (Alternately, you may click here to make a request for a personalized property value analysis.)

If you are interested in making a purchase or exchange of a property, please phone Shayne Bowen at 707 577-8200! (Alternately, you may click here to request information on potential properties for you.)