What critical question this episode answers: How do you best structure the representation of a client in a qualified §1031 transaction? Watch/read here.
The prior episode in this series covers the broker’s efforts to locate a ready, willing and able buyer at the asking price.
An additional fee-generating opportunity
Often, the property available for sale is held by the owner as an investment or for use in their business. Investment property includes income property and vacant land held for profit. Business property is property used in the owner’s trade or business and held for over one year.
Taxwise, investment and business property are classified as like-kind (§1031) property for purposes of avoiding California and federal income tax reporting of any profit on its sale. [Internal Revenue Code §1031]
Property classified as the seller’s principal residence or held out for sale as dealer property, such as the resale of lots created by a developer, is not like-kind §1031 property.
When the net sales price on the sale of §1031 property is greater than the owner’s remaining cost basis in the property, the seller takes a profit on the sale which is not reported and thus not taxed in a fully qualified §1031 transaction.
A seller broker alert to an opportunity to provide additional fee-generating services coupled with the sale of investment or business property discusses a §1031 reinvestment plan with the client. The seller broker reviews with the seller-client:
- locating suitable property for reinvestment;
- closing the sale of §1031 property;
- proper transfer of net sales proceeds; and
- closing the purchase of §1031 reinvestment property within §1031 time periods.
On replacement of the like-kind property, the seller avoids reporting profits and paying income taxes on the profit taken on the sale. The §1031 formula for avoiding profit taxes is to acquire replacement property with:
- an equal-or-greater equity than the property sold; and
- equal-or-greater debt than encumbered by the property sold.
The net sales proceeds generated on the property sold are:
- directly disbursed to the purchase escrow for the reinvestment property acquired; or
- held by an intermediary for no more than the permissible time period before taking title to the reinvestment property.
As in any employment of a broker by a buyer-client, the right to locate — buy — replacement property and earn a fee mandates the broker enter into a written buyer representation agreement with the client. The written agreement to employ is needed both to enforce collection of a fee and comply with Department of Real Estate (DRE) licensing law. [Calif. Civil Code 1670.50(e)]
An exclusive seller representation agreement achieves compliance with licensing law through its replacement property fee provision. An additional separate exclusive buyer representation agreement with the client is not necessary but might be best used when the seller-client decides to become, also, a buyer-client.
However, different retainer period rules apply when representing buyer-clients who are individuals — but not so for entities. The representation period for an individual buyer is inconsistent with the rules controlling retainer periods when representing individual sellers. No distinction exists for entities whether they are buyers or sellers. [See RPI Form 103.1 and 103.2]
Thus, to best protect their fee when representing an individual client in an exchange of properties, the prudent broker enters into two separate representation agreements:
- one is a seller representation agreement employing the broker to sell or exchange the individual seller-client property [See RPI Form 102];
- the other is a buyer representation agreement authorizing the broker to locate property to be acquired by the client as §1031 reinvestment property.
In an exchange, the client takes on both the role of a seller — and a buyer.
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