The overwhelming majority of 1031 Qualified Intermediaries base their business on the profit potential from delayed exchanges. In a delayed exchange, the Relinquished Property is sold and the cash proceeds from the sale are entrusted to a QI until it is time to acquire the Replacement Property. QIs aggregate these exchange proceeds into large deposits and expend a good deal of energy finding the best yield (highest interest rate) from one or more banks. Given current interest rates, most QIs keep all of that interest. Even deposits made under the plans that yield zero interest while offering unlimited FDIC coverage generate income for the QI by virtue of “behind the line” marketing fee arrangements.
From the Exchangor’s view, if a deferred or delayed exchange has been used, the Relinquished Property has been liquidated and the financial benefits (e.g. rent or lease income, depreciation, utilization) it was providing stop because title has changed hands and the cash sale proceeds have been given over to the QI. The reality is that the Exchangor’s Return on Capital (“ROC”) during a delayed exchange is usually drastically smaller, if not zero, because that cash is now generating income for the QI. In other words, there is a cost to the Exchangor, expressed in terms of lost ROC, associated with performing a delayed exchange. The larger the value of the asset, the more income it generates for the QI. QIs generally offer to perform delayed exchanges for a very small transaction fee as an enticement for the deposits. Competition among QIs has frequently centered on this type of fee strategy and has enabled the typical delayed exchange fee to remain very small relative to the actual income earned by the QI.
Reverse exchanges have larger fees because they are inherently more complex and because there are no exchange deposits which earn interest. Many QIs incorporate in their marketing and sales messages the idea that reverse exchanges are “more expensive” than delayed exchanges. While this can be true, depending on a particular set of facts and circumstances, it is not necessarily so. It is seldom a question of comparing the delayed exchange fee (typically between $750 and $1,500) with the fee for a simple reverse exchange (typically $5,000 or more). The real cost of a 1031 exchange must be evaluated using both fees and ROC during the exchange period as the major factors.
In a reverse exchange, either the Relinquished Property or the Replacement Property is “parked” with the Accommodator. At the same time, the Exchangor leases the parked property from the Accommodator with very favorable terms - a triple-net lease at zero rent, or rent exactly equal to the debt service if there is a loan, which gives the Exchangor 100% of the financial benefits (except depreciation) coming from the parked property. Since the other asset involved in the exchange is owned by the Exchangor during the exchange, the Exchangor is receiving financial benefits from both properties during the exchange. In other words, during a reverse exchange, there may be significant ROC based on income streams coming from two assets and the benefit of this “leverage” belongs to the Exchangor and the Exchangor alone.
A simple illustration follows that involves a hypothetical exchange of two income-producing properties. The Relinquished Property generates rent and depreciation benefits for the Exchangor. The Replacement Property also generates rent but cannot be depreciated by the Exchangor while title to it is held by the Accommodator.
|Relinquished Property||Replacement Property|
|CAP Rate, triple-net||6%||7%|
|Monthly income, pre-tax||$7,500||$12,167|
|3-Month Exchange||Delayed||Exchange Last|
|Total pre-tax income||$0.00||$59,000|
|Interest on proceeds (0.25%)||$875||$0.00|
|Cost of Advanced Money (1%)||$0.00||$3,500|
|Total income, pre-tax||$125||$50,500|
As you can see, a delayed exchange has significant financial disadvantages even when factors such as depreciation, the cost of money to acquire the Replacement Property and increased income taxes are taken into account.
Of course, it’s seldom this simple. The point is that developing the optimal exchange strategy for a particular exchange should include a calculation of the real cost of the exchange and that calculation should involve more than simply the fees charged by the QI.
We have deployed both spreadsheets and online calculators, in our Resources section, which contain a model for analyzing this type of ROC or "cost" comparison. Detailed examples are also provided. Feel free to modify the spreadsheets as you see fit. Of course, the spreadsheets and calculators are only tools and we cannot accept responsibility for their accuracy, results or the consequences of any decision based on the results that they produce.