Fourth in a series of articles.
Real estate investors large and small pay capital gains tax when they sell their property -- and the bills can be sizable.
There is a way, however, of deferring payment of this tax, known as a "like-kind" exchange, under Section 1031 of the Internal Revenue Code. It's also called a Starker exchange or a deferred exchange.
It's not tax-free, because it will not relieve you from the ultimate obligation to pay the capital gains tax. It will, however, allow you to defer paying that tax until you sell your last investment property.
The ideal exchange is a direct exchange: I own investment property A and you own investment property B. They are of equal value. On Feb. 1, you convey property B to me and I convey property A to you. If there is a written agreement between us that this is to be a 1031 exchange, for now neither of us will have to capital gains tax on any profit we have made.
Such a transaction is rare -- finding property for a simultaneous swap is difficult, if not impossible. However, some years ago, a man by the name of T.J. Starker sold property in Oregon, pursuant to a "land exchange agreement," but did not receive any money for the sale. Instead, the seller -- a couple of years later -- transferred replacement property to Starker. The Internal Revenue Service considered this a taxable sale, but the courts held that this was permitted under Section 1031.
In other words, the exchange did not have to take place simultaneously. That opens up all sorts of possibilities for investors.
There are two kinds of deferred (Starker) exchanges:
Forward exchange. You sell the relinquished property, and within the time limits spelled out in the law, you obtain the replacement property.
Reverse exchange. You obtain title to the replacement first, and then sell the relinquished property.