In this article, I'd like to define two real estate terms—direct deeding and
sequential deeding—and show the best form to use with 1031 Tax Deferred
Exchanges.
If you're not familiar with the "1031," this law allows the
exchange of investment or business property for other investment or business
property, without paying tax (it's deferred) if the property received is
"like kind."
As you'll see below, direct deeding is the better choice in this
situation, but it's important to understand the difference between the two
options so you're armed with full knowledge when you enter into a 1031
Exchange.
Direct Deeding and Sequential Deeding
Direct deeding is a process of deeding property directly to the buyer
rather than to an intermediary (the initial common method in 1031 tax
deferred exchanges). The seller of the property deeds his or her property
directly to the buyer, skipping the deed to an intermediary.
In 1990, the IRS ruled that it was no longer necessary to use
"sequential" deeding in a tax-deferred exchange transaction. With the
sequential deeding method, the seller's deed is given to an intermediary who
then deeds the property to the buyer.
Most property transfers in tax-deferred exchanges today use "direct
deeding" rather than "sequential deeding."
The Advantages of Direct Deeding Over Sequential Deeding
Under sequential deeding, the intermediary is exposed to the risk of
liability (asbestos, environmental hazards, etc.) for the short time they
hold title. Direct deeding reduces those risks.
Another advantage of direct deeding is cost savings. It eliminates the
payment of duplicate transfer taxes which are normally charged each time a
deed is recorded.
Safeguards To Follow in the Direct Deeding Process
It's a necessity to use a fully qualified intermediary. Check ahead of
time so you know that the intermediary is qualified and has experience. You
definitely don't want a "newbie" or an incompetent handling a 1031
transaction.
As a seller, ensure that the intermediary has an agreement with your
buyer for the transfer of the property to be exchanged.
As a buyer, make sure that the intermediary has an agreement with the
seller of the property which allows for the transfer of that replacement
property to you.
Additional Information On Intermediaries
All parties to the agreement must be notified in writing of your
intention to use an intermediary in the exchange. In typical cases, the
qualified intermediary in your exchange is affiliated with a title or escrow
company. The title or escrow company provides all the services required to
handle the closing; e.g., title insurance, escrow services, and document
preparation and transfers, etc.
There are several advantages to using a professional intermediary in a
1031 exchange, including:
Reduction of the potential liability for the structure of the exchange
and any tax consequences.
Shielding of the principals from accepting additional liability.
Provision of a paper trail by way of the assignments and exchange
agreements.
The 1031 Tax-Deferred Exchange is a great mechanism for deferring taxes.
However, it can be a complicated process, so it's best to be fully-informed
on these transactions.
Key Point: If you're new to 1031s, absolutely seek the advice of a tax
professional who's experienced in exchanges!
By Jack Sternberg is a nationally recognized expert on real estate
investment who's been in the business for more than 30 years. Sternberg's
deals have totaled over $750 million and he's been to the closing table more
than 1,500 times. For more, visit http://www.askjacksternberg.com
