By Benny L. Kass
Saturday, January 24, 2009
Fourth in a series of articles
"The income tax has made more liars out of the American people than golf has."
-- Will Rogers
While there may be no such thing as a free lunch, a Starker exchange is about as close as you can get.
Such an exchange is also known as a like-kind or Section 1031 exchange, after the part of the tax code that permits it. It is a way to get rid of one investment property and replace it with another while avoiding tax on the deal. Technically, instead of selling one and buying another, you're trading them. It's not "tax free," as it is often erroneously described, but it does allow you to defer your income tax to a future day.
There is concern in the investment community that the Obama administration will increase the capital gains tax rate from 15 percent to something higher. So now is the time to seriously consider such an exchange.
To understand how the exchange works, you have to use the proper vocabulary. Your current property is called the relinquished property. The new property is called the replacement property.
The rules are simple, but implementation can be tricky. If you do not follow the rules, your exchange will fail and you will have to pay the tax.
When you go to settlement on the relinquished property, all of the net sales proceeds must be put in escrow with what is called a qualified intermediary. This can be a professional exchange company, a bank or a lawyer who has not represented you in the past two years. Why escrow? You cannot have control of the sales proceeds for even one minute.
From the day you sell the relinquished property, you have 45 days to identify the replacement property. Multiple properties may be identified, within limits, but one of them must be the one to which you eventually take title. You have to be specific in your identification; you cannot just say "that house over there on Main Street."
You must take title to the replacement property within 180 days from the date you went to settlement on the relinquished property. (There is one caveat: If your income tax return comes due within the 180 days, you have to either get an automatic extension by filing Form 4868 or complete the transaction. Note that although your tax return can be extended, you still must pay your taxes by the original deadline.)
The Internal Revenue Service takes the exchange deadlines seriously. Even when intermediaries have gone out of business, taking their clients' money with them, the deadlines have remained in force. That means people who thought they were setting up tax-deferred transactions instead ended up owing tax on the original property sale.
Technically, you assign the intermediary the sales contracts for both the replacement and relinquished properties. But the IRS allows direct deeding from buyer to seller, so in reality the intermediary is just a formality. But it is a formality that is mandatory.
There are many complex issues involved:
· Like kind. For a successful exchange, both properties must be held for investment. And both have to be "like kind." As long as you are exchanging real property, you should be safe. A condominium can be exchanged for an office building, a farm for a shopping center, raw land for a single-family house. But real estate can't be exchanged for stock.
· Title. The replacement property must be titled in the same manner you held the relinquished property. However, if you owned the former property in your name, you can take the replacement property in the name of a single-member limited-liability company. This is considered a "disregarded entity" for tax purposes -- that is, it's ignored.
· Tax basis. Because you defer paying capital gains tax, the tax basis of the relinquished property becomes the tax basis of the replacement property. Even though the later may have cost $500,000, if the basis of the former was only $200,000, that will become the new basis. This is why it is called a tax-deferred exchange. Unless you die -- or establish the new property as your principal residence -- when you sell the replacement property, you will have to pay the full amount of the tax you deferred, plus on any appreciation on the new property.
· Tenant-in-common arrangements. In recent years, promoters have created what is known as fractional ownership. One variation is tenants-in-common, or TIC, ownership. Another is a Delaware statutory trust. Under these plans, you can use the proceeds from the sale of the relinquished property to obtain a part interest in another, larger U.S. property, and it will qualify as a successful exchange.
Such plans are aggressively promoted to prospective investors. Make sure you fully understand all the ramifications of the plans, and talk with your tax and legal advisers before you make any formal commitment.
· Vacation homes. In general, a vacation home is not property held for investment and cannot be used in a 1031 exchange. However, in March, the IRS announced in Bulletin 2008-10 that it would not challenge whether a property was an investment if (1) it is owned by the taxpayer for at least 24 months immediately before the exchange, (2) the taxpayer rents the property at a fair rental rate for 14 days or more per year, and (3) the period of the taxpayer's personal use does not exceed the greater of 14 days or 10 percent of the number of days that the property was rented for each of the two years referenced above.
I suspect that the IRS will be looking very carefully at exchanges involving vacation homes. While it is now possible to perform such an exchange, you must have complete documentation to prove that you actually rented out your summer home and did not use it beyond the time limit.
· Reverse exchanges. Say that you have found the ideal exchange property but have not been able to sell the relinquished property. The IRS has blessed an exchange wherein you obtain title first to the replacement property and then sell your current property, under the same time limits outlined above. The rules are complex, and you must discuss this with a real estate expert.
· Tax reporting. If you have engaged in a Starker exchange, you must file IRS Form 8824 with your tax return for that year. You can find the form on the IRS Web site, http://www.irs.gov.
Next Saturday: Saving tax records.
Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, http://www.kmklawyers.com.