This article instructs an agent how to diligently represent a seller of real estate who is willing to exchange their property for another more suitable property.
Swapping an equity in real estate
Actual property exchanges occur most frequently during a recession, when buyers are unable — or unwilling — to part with cash. Since the inventory of properties whose owners need to sell are plentiful and buyers with cash are not, an increase in property exchange activity is the natural result. Importantly, it is brokers and their agents who facilitate exchanges — they are the gatekeepers to the market of real estate transactions.
As we head into the 2023 recession, agents who want to remain relevant and step ahead during these times of economic downturn will become versed in property exchanges, also called a two-party exchange or a two-way exchange. In these transaction, two owners trade equity for equity, disposing of the property exchanged for the property acquired. [See RPI e-book Tax Benefits of Ownership]
An exchange of properties is a multi-property transaction structured as a barter agreement — a swap — entered into by the separate owners of two or more parcels of real estate.
Using an exchange agreement, they transfer to one another the ownership of their properties, conveying them through concurrent closings in consideration for receiving the value of the equity in the property they acquire.
The exchange transaction, often called a trade, is in fact separate sales of two properties each owned by different persons. Brokerage fees are collected and shared, paid by the owners of each property.
Equity adjustments in a property exchange
Financial adjustments need to be arranged when there is a difference in the dollar amount of equity in each property. The equity agreed to in each property is based on the value — price — given each property in the exchange agreement. The values given are not part of and do not affect income tax reporting. However, the mortgage amounts are part of tax reporting on the property conveyed and the cost basis for depreciating the property acquired in the transaction.
Unlike the sale of a property using a purchase agreement, the down payment on the property acquired is not in the form of cash. Rather, the down payment is the equity in the property the owner will transfer in the exchange. [See RPI Form 150 §11.6]
Any balance of the price remaining to be paid in an exchange is most often deferred, evidenced by a carryback note and trust deed, not cash. Exchanges frequently have little to no cash involved beyond transactional costs, a side effect of the recessionary times when Cash as King stays with the throne and equity exchanges are most prevalent.
Adjustments made in a conventional sale to pay the difference between a cash down payment and the mortgage amount, such as a carryback note, are the same for payment of the difference between the amounts of equities in an exchange transaction, called a balancing of equities.
The equity adjustment in an exchange arises when the equity in one property is larger than the equity in the other property. Here, the owner of the larger equity receives the consideration given for the adjustment by the owner of the lesser equity, such as a carryback note, other property or possibly cash.
Cash sales versus profit tax exemption
An exchange is unlike a cash sale which “frees up” the capital invested in real estate by converting a seller’s equity to cash on closing. In contrast, an exchange continues the owner’s investment in real estate, moving their wealth in one property to another.
In an exchange, the owner disposes of a property they possess and no longer want and acquires one they want, or would rather own. Further, whatever other factors may motivate an owner to participate in a property exchange, the §1031 profit tax exemption is always one of them.
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Editor’s note — In a conversion, an owner who has already entered into a purchase agreement to sell their property to a cash buyer may before closing (after tax counseling) want to include the sale in a §1031 reinvestment plan. Here, their agent locates a suitable replacement property, then prepares and submits a separate purchase agreement offer to buy a replacement property. No exchange agreement is entered into as no exchange exists — just a sale of one property and a purchase of another, coupled solely by a proper transfer of sales proceeds as part of a §1031 investment plan. [See RPI Form 159]
A walk-through example of trading up
Consider an agent working with an investor who wants to get out from under the management burdens of a smaller residential rental property they own. The investor prefers to own a single-user property requiring little of their time to oversee maintenance and repairs; a net lease agreement situation. [See RPI Form 552-2]
The agent’s broker and investor enter into a property listing agreement. A reinvestment provision in the agreement is activated, calling for the location and acquisition of like-kind replacement property. Thus, the owner’s agent is employed to maintain the client’s continuing investment in real estate. A continuing investment by timely acquiring replacement property is required to qualify the profit taken on a sale for the §1031 exemption from taxation. [See RPI Form 102 §9]
The agent attends a marketing session, called an exchange or investment group. At the meeting, the agent “pitches” their listed property and advises attendees about the type and location of property their clients are willing to take in exchange, where they meet an interested agent.
To track responses for the possibility of an exchange and document the inquiry for later follow up, the agent prepares a preliminary proposal form and delivers it to the other agent to encourage continued discussions.
The proposal form:
- notes the type of properties involved;
- notes the amount of equity and debt; and
- arranges for the exchange of property information and a discussion between the agents before preparing an exchange agreement.
The agent retains a copy of the prepared form in their client file as evidence of the agent’s due diligence to locate property. The agent emails the client every two weeks to advise on the agent’s marketing activities and keep the client involved for likely feedback. [See RPI Form 170]
Editor’s note — The preliminary proposal is not an offer. As a proposal, it does not contain intent-to-contract wording. The clients are not directly involved in the proposal, only the agents who are looking for a possible match.
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Analyzing the flow of considerations
Once the agent locates like-kind replacement property whose owner indicates a willingness to consider an exchange, the market value of the properties needs to be established. Valuation then becomes the single most important task for negotiating an exchange agreement since the dollar amount of the equity in each property — the wealth involved — is dependent on the current value of each property.
Depending on the likelihood of a transaction taking place, comparative market data may need to be gathered and reviewed. [See RPI Form 200-1]
On determining the dollar value of the equity in each property, the agent proposes adjustments to cover the difference between the equity valuations in each property. This discussion is with the agent representing the other property owner, then the client.
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Form-of-the-Week: A comparative market analysis for setting prices and rents — Forms 318 and 318-1
Through the networking process, the agent locates an industrial property owned by a business entrepreneur. Their company occupies the entire building. The entrepreneur’s agent explains their client intends to lease back the property from the buyer, not move. The entrepreneur’s objective is to reduce debt as they need to increase their credit line for business operations.
The investor’s units are priced at $1,500,000 with a debt of $500,000 and equity of $1,000,000. The entrepreneur’s industrial building is listed at $3,000,000 subject to a mortgage of $1,750,000 with equity of $1,250,000.
Discussions and initial analysis completed, the agent prepares an exchange agreement offer. The offer is based on the investor’s and the agent’s analysis of valuations, including the:
- fair market value (FMV) of each property to be exchanged [See RPI Form 171 §§1.3 and 2.3];
- mortgage amounts encumbering each property, and whether they are to remain of record in a subject to closing; and
- equity valuations calculated as the FMV of each property, minus the remaining principal amount of existing mortgages.
Since the equities in properties exchanged are rarely the same dollar amount, negotiations nearly always include adjustments. The adjustments contributed by one owner include cash, which is figuratively called a sweetener, a carryback promissory note, or personal property, collectively called cash boot. Sometimes even additional real estate is included for its equity value. It is the owner of the property with the lesser amount of equity who adds cash or other considerations to adjust for the dollar difference in equities.
An exchange has its terms and conditions
In our example, besides the routine due diligence investigation into each property, necessary contingencies and closing provisions, the agent needs to negotiate:
- the adjustment for the $250,000 difference between the equities in the two properties; and
- the terms of a lease for the entrepreneur’s continued occupancy of the industrial building. [See RPI Forms 552-2; 552-3]
The terms in the investor’s exchange agreement for their payment of the $3,000,000 price for the industrial property to be acquired include:
- the $1,000,000 equity in the investor’s residential units to be transferred — the down payment;
- the $1,750,000 mortgage the investor assumes on the industrial property to be acquired — the primary financing; and
- a $250,000 note and trust deed executed by the investor in favor of the entrepreneur — the adjustment needed to balance the equities between the two properties in the exchange.
On the flip side of this exchange, the consideration the entrepreneur will provide the investor for taking ownership of the investor’s mortgaged residential units and receiving the carryback note, which includes:
- the $1,250,000 equity in the industrial property; and
- an assumption or refinance of the $500,000 mortgage on the residential units.
Thus, with the entrepreneur’s receipt of a $250,000 carryback note secured by the industrial building, the total consideration the entrepreneur is to pay for the residential units is $1,000,000 on acceptance of this offer and the assumption of the mortgage on the units.
Editor’s note — When existing financing encumbers the properties being exchanged, negotiations may call for the mortgages to remain of record or be paid off and reconveyed. Refinancing of the replacement property may be necessary to generate cash funds to pay off and reconvey the existing mortgages and pay transactional costs. When additional cash is required for these purposes, a contingency provision for new financing needs to be activated.
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Closing the exchange escrows
The leaseback arrangement the investor offers is based on the FMV of the industrial property and rents recently agreed to for comparable properties. The terms of the lease are set in an addendum attached to the exchange agreement offer (which may well be a proposed lease agreement).
On receiving and reviewing the offer, the entrepreneur’s agent submits a counteroffer based on the terms of the exchange agreement, modified as follows:
- the carryback note provision is deleted; and
- the amount of $250,000 to be paid in cash to adjust the equities.
Ultimately, escrow is opened based on a downward adjustment in the price of the industrial building by $25,000. The adjustment for the difference in equities becomes $225,000, payable by a $125,000 note and $100,000 in cash.
With this exchange, the investor has moved their equity into property of greater value, and thus greater mortgage debt. In this way they increased the leverage on their equity to more quickly build up their wealth by periodic mortgage amortization, asset inflation, and appreciation due to demographics.
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