The right way to trade property with a Starker exchange

By Benny L. Kass
Washington Post Staff Writer
Saturday, February 6, 2010

Say you own property in Rehoboth Beach, Del., which calls itself "our nation's summer capital." It has appreciated greatly over the years, but now you want to sell it. You have heard that you can defer any capital-gains taxes by doing a Starker exchange under Section 1031 of the Internal Revenue Code.

How do you go about this?

In a valid Starker exchange, you may swap investment properties only with other investment properties. You cannot exchange your principal residence or a home used primarily for vacation. So the question of whether you can defer tax on capital gains by using a Starker exchange depends on the way you use that Rehoboth property.

When discussing the 1031 exchange, it is important to use proper terminology. The property you want to dispose of is the "relinquished property." The new one is the "replacement property."

For a relinquished property to qualify for the exchange, it must have been owned by the taxpayer for at least 24 months immediately before the exchange. The Internal Revenue Service calls this the "qualifying-use period."

Additionally, for each of the two years in the qualifying-use period, the owner must have rented the property, charging a fair-market rent for at least 14 days. The owner cannot have used it personally for more than 14 days or 10 percent of the number of days during each 12-month period that the property is rented.

That sounds confusing, but it is the law. The IRS does not want taxpayers claiming properties as "investments" when in fact they take their families to the beach for the entire summer, or even a significant part.

These requirements have been upheld by the tax court, which handles a number of taxpayer disputes with the IRS. In one case, the owner exchanged one lakeside property for another. Neither home was rented out, and both were used exclusively for personal purposes. The owner argued that he knew the properties would appreciate and thus held them for investment purposes. The tax court disagreed, stating that "the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence."

You can, of course, inspect your second home periodically, and make repairs. However, if that use exceeds the use restrictions described above, you will not qualify for a Starker exchange. Confirm this with your own accountant.

What is "fair rental"? The IRS relies on its standard formula: It will look to the facts and circumstances of each case. To be on the safe side, have at least two real estate agents provide you with a written market analysis of rent rates for similar properties in the areas where the relinquished and replacement properties are.

What about the replacement property? Here, the same rules apply. If you swap, you must rent out the replacement for at least two years or the exchange will fail. According to the IRS: "If a taxpayer files a federal income tax return and reports a transaction as an exchange under ยง1031, based on the expectation that a dwelling unit will meet the qualifying use standards . . . and subsequently determines that the dwelling unit does not meet [those] standards, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange."

That could create a financial disaster. Say you did a 1031 exchange, and you have to use all of the proceeds from the sale of the relinquished property to obtain the replacement. Then you fail to meet the requirements and have to file an amended return -- and pay the tax on the capital gain. Where will you get the money to pay the tax?

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