Bending Starker Exchange Rules Can Be Risky Business

By Benny L. Kass
Saturday, April 22, 2006

Q: What can you do with the investment property you have obtained by way of a Starker exchange? No one I know who has done an exchange has, in my opinion, kept the property as investment.

Three examples:

· A person buys a house as a second home. His lawyer tells him that as long as he runs an ad in the paper showing that he tried to rent the property he can satisfy the IRS questions. He has used the house as a second home for the entire time he has owned it. He runs the ad in an out-of-the-area newspaper and no one has called.

· A couple bought their house as an exchange property and have used it as a second home, too. They run a small business, so to show that the property is rented they just rent it to themselves under the name of the business.

· Another person bought a house and, while he uses the property on a regular basis, he gets a friend to write him rent checks so he can show he rented it. He uses the property more than 14 days per year and lets relatives use it during the year as well.

Does the IRS check on these transactions? If all we have to do is fill out paperwork for a Section 1031 exchange, we all might as well say we did an exchange and not pay taxes on our second homes. Is it so easy to fool the IRS?

A Very interesting. My quick answer: Go directly to jail. Do not pass Go.

I do not know how many 1031 exchanges the IRS audits every year, although I do know that any such exchange is subject to review by an IRS employee.

I also know that if these friends and neighbors ever get caught, they will be in serious legal and financial trouble.

Starker exchanges have become very popular in recent years, especially as real estate prices have been escalating. A Starker exchange is authorized by Section 1031 of the Internal Revenue Code, and is also referred to as a 1031 exchange. Some people mistakenly call it a "tax free" exchange, but that is not exactly correct. It is a tax-deferred exchange.

You cannot exchange your personal residence, but after you sell a principal residence, such as the exclusion from capital gains tax of up to $500,000 in profit for couples filing a joint tax return. (To qualify, you have to have lived in and owned the residence for two out of five years previous to the sale. If you file a separate tax return, you are eligible for up to $250,000 exclusion of profit).

If you own investment property and sell it, you will have to pay 15 percent to the IRS on any profit you have made. In addition, depending on where your property is, you may have to pay a similar state capital gains tax.

CONTINUED     1        >

© 2006 The Washington Post Company