Nobody wants to pay tax when they sell their
investment real estate.. If you sell your principal
residence, and have lived there for two out of the
past five years before it is sold, you can
completely exclude up to $250,000 of any gain you
have made ($500,000 if you are married and file a
joint return).
But if you sell investment real estate, you will
have to pay the capital gains tax unless you engage
in some creative tax activities. One such procedure
is known as a Starker (or "deferred") Exchange,
named after Mr. Starker. Starker had to all the way
to the Supreme Court, but he established a basic
principle: if you exchange one property for another
-- even if the replacement property is obtained at a
later date -- under section 1031 of the Internal
Revenue Code you do not have to pay tax on the sale.
Instead, the basis of the old (relinquished)
property becomes the basic of the new (replacement)
property.
Congress did not like the fact that several years
had elapsed between the time Starker sold the
relinquished property and the time he obtained the
replacement property. Thus, Congress set strict,
non-waivable time limitations. You must identify the
replacement property (or properties) within 45 days
from the date you sell the relinquished property,
and you must take title to that property within 180
days from the earlier sale.
Currently, the capital gains tax rate is 15
percent on the amount of any appreciation and 25
percent on the amount you have depreciated. If you
sell your investment property and buy another one
within the time frames spelled out by Congress, you
will defer not avoid having to pay the capital gains
tax now.
Some people just do not want to continue to be
landlords, and may want to "bite the bullet" and pay
the tax. But , in my opinion , the exchange
provisions of the Internal Revenue Code are l an
important tool for any real estate investor.
The law establishing this like-kind exchange can
be found in Section 1031 of the Internal Revenue
Code. The rules are complex, but here is a general
overview of the process.
Section 1031 permits a delay (non-recognition) of
gain only if the following conditions are met:
First, the relinquished property transferred and
the replacement property must be "property held for
productive use in trade, in business or for
investment." Neither properties in this exchange can
be your principal residence, unless you have
abandoned the property as your personal house.
Second, there must be an exchange; the IRS wants
to ensure that a transaction that is called an
exchange is not really a sale and a subsequent
purchase.
Third, the replacement property must be of "like
kind." The courts have given a very broad definition
to this concept. As a general rule, all real estate
is considered "like kind" with all other real
estate. Thus, a farm can be exchanged for a
condominium unit, a single family home for an office
building, or raw land for commercial or industrial
property.
Once you meet these tests, it is important that
you determine the tax consequences. If you do a
like-kind exchange, your profit will be deferred
until you sell the replacement property. However,
since the cost basis of the new property in most
cases will be the basis of the old property, you
should review your situation with with your
accountant to determine whether the savings by using
the like-kind exchange will make up for the lower
cost basis on your new property.
The traditional, classic exchange (A and B swap
properties) rarely works. Not everyone is able to
find replacement property before they sell their own
property. In a case involving Mr. Starker, the court
held that the exchange does not have to be
simultaneous. However, as discussed above, there are
now strict time limitations imposed by law on when
the exchange must take place. These are very
important time limitations, which should be noted on
your calendar when you first enter into a 1031
exchange.
In 1989, Congress added two additional technical
restrictions. First, property located in the United
States cannot be exchanged for property outside the
United States.
Second, if property received in a like-kind
exchange between related persons is disposed of
within two years after the date of the last
transfer, the original exchange will not qualify for
non-recognition of gain.
In May of 1991, the Internal Revenue Service
adopted final regulations which clarified many of
the issues.
This column cannot analyze all of these
regulations. The following, however, will highlight
some of the major issues:
1. Identification of the replacement property
within 45 days According to the IRS, the
taxpayer may identify more than one property as
replacement property. However, the maximum number of
replacement properties that the taxpayer may
identify is either three properties of any fair
market value, or any number of properties as long as
their aggregate fair market value does not exceed
200% of the aggregate fair market value of all of
the relinquished properties.
Furthermore, the replacement property or
properties must be unambiguously described in a
written document. According to the IRS, real
property must be described by a legal description,
street address or distinguishable name (e.g., The
Camelot Apartment Building)."
2. Who is the neutral party? Conceptually,
the relinquished property is sold, and the sales
proceeds are held in escrow by a neutral party,
until the replacement property is obtained. Usually,
an intermediary or escrow agent is involved in the
transaction. In order to make absolutely sure that
the taxpayer does not have control or access to
these funds during this interim period, the IRS
requires that this agent cannot be the taxpayer or a
related party. The holder of the escrow account can
be an attorney or a broker engaged primarily to
facilitate the exchange, although the attorney
cannot have represented the taxpayer on other legal
matters within two years of the date of the sale of
the relinquished property.
3. Interest on the exchange proceeds . One
of the underlying concepts of a successful 1031
exchange is the absolute requirement that the sales
proceeds not be available to the seller of the
relinquished property under any circumstances unless
the transactions do not take place.
Generally, the sales proceeds are placed in
escrow with a neutral third party. Since these
proceeds may not be used for the purchase of the
replacement property for up to 180 days, the amount
of interest earned can be significant.
Surprisingly, the Internal Revenue Service
permitted the taxpayer to earn interest -- referred
to as "growth factor" -- on these escrowed funds.
Any such interest to the taxpayer has to be reported
as earned income. Once the replacement property is
obtained by the exchanger, the interest can either
be used for the purchase of that property, or paid
directly to the exchanger.
There is an interesting loophole which may be
attractive to many readers who currently own rental
property. Let us assume that you have found your
dream house in Florida, or in Delaware or anywhere
in the United States for that matter. This is where
you want to live after retirement. If you do a 1031
exchange now, and obtain title to the replacement
property where you ultimately want to live when you
retire, you can rent out that property until you
decide to move. Then, once you have established the
new property as your principal residence, if you
live in it for at least two years and more than two
years have elapsed since you sold your last
principal residence once again you can exclude up to
$250,000 (or $500,000 if married and you file
jointly) of the gain you have made.
Although the IRS has given us no guidance as to
how long you have to use the replacement property as
"investment" property, the general consensus is that
you should rent out the property for at least one
complete tax year.
Thus, depending on the numbers and the facts, you
may ultimately be able to avoid the capital gains
tax which would normally be due when you sold your
investment property.
The IRS has also authorized taxpayers to engage
in "reverse Starkers", where you buy the replacement
property first and then exchange (sell) the
relinquished property. This is much more complex,
and you have to get specific guidance from your own
tax advissors.
The rules for a "like-kind" exchange are not
complex -- but must be strictly applied.. You must
obtain competent, professional financial and legal
assistance if you plan to go this route.
We have a network of
professionals trained to handle 1031 exchanges.
Use the link in the upper right hand corner to send
us an e-mail and a professional will contact you
within 24 hours.
