Colonnade publishes industry commentary on Section 1031 Like-Kind Exchanges.
For almost 100 years, the tax laws of the United States have allowed investors to defer taxes on the gains generated by a property sale if the proceeds are properly re-invested in a “like-kind” property. This form of tax deferral is governed by Section 1031 of the Internal Revenue Code (IRC). IRC Section 1031 details a set of rules that allow investment or business-use real estate like-kind exchanges (LKE). The rules created the need for independent parties, Qualified Intermediaries (QIs), to facilitate the like-kind exchanges and hold the sales proceeds while a suitable property is identified and acquired.
Qualified intermediaries facilitate, provide reports to the taxpayer, and generally manage exchange transactions for taxpayers. In a typical transaction, the QI technically acquires the relinquished property from the taxpayer and transfers it to the buyer. The QI later acquires the replacement property from the seller and transfers it to the taxpayer. Hence it is acting as an intermediary in connection with the transaction. QIs receive fees for the services and, as a secondary function, generally hold the funds generated by the sale of the relinquished property while the exchange is arranged and completed. The funds are generally placed in interest-bearing accounts and/or short-term investment funds; and the QI and taxpayer may share the interest or investment income. Any portion of the earnings which are received by the taxpayer are considered interest income and are taxable. LKE transactions are an important tool for commercial real estate investors and business-use taxpayers and gather low-cost, stable deposits that generate fees and earnings on the deposits for 1031 exchange providers.
Qualified intermediaries generate significant earnings from an asset-light business model based on deep technical expertise and strong referral relationships with brokers, attorneys, and accountants and others. Strategic and financial buyers have shown interest in the sector, but banks seeking a low-cost source of deposits have the strongest incentive to enter the industry at this point in the economic cycle. We expect that many 1031 exchange owners will seek to monetize their investments in the next 18 months, now that conditions for the like-kind exchange industry are favorable.