Delayed investment property exchanges are not subject to taxation, an appellate court ruled recently. The decision is expected to give considerable impetus to such transactions on the West Coast, where the case originated, although it is not yet clear how it will affect the rest of the country.
Exchanging -- rather than selling -- business land or buildings of "like kind" has become an increasingly popular way to avoid paying capital gains taxes.
For example, an owner whose undeveloped land has tripled in value may elect to swap his equity interest in that land for one of the same value in an apartment building. The owner can then trade up his interest in the apartment building for one in an industrial complex, and so on.
Taxes on the gains on all these exchanges can be deferred indefinitely until final sale, while the owner takes advantage of depreciation. There is no limit to the number of transactions an individual can make. Primary residential property, such as one's home, is excluded.
In a landmark decision last month in the case of Starker v. United States, the 9th Circuit Court of Appeals upheld a verdict against the Internal Revenue Service, which had claimed that no true property exchange had taken place.
The defendant, B. J. Starker of Columbia County, Ore., had agreed to trade timberland worth $1.4 million to Crown Zellerbach, the San Francisco-based paper and pulp company, in exchange for unspecified properties, because the company had no land Starker desired at the time. They signed an agreement saying that if at the end of five years the exchanges had not been made, Starker would get $1.4 million plus 6 percent interest.
Within two years Crown Zellerbach had turned over 12 parcels of land to Starker. The IRS said this was not an exchange because a substantial time had elapsed between the transactions. The case gets rather complicated because of cross ownership with Starker's son, Bruce. But in the end the appellate court ruled that the father did not have to pay taxes on 10 of the 12 properties.
One of the two rejected was his personal residence and the other was deeded to a daughter. Nine of the properties were jointly owned by father and son. The IRS had moved against the son, and lost. The appellate court upheld the lower court with respect to the nine properties.
That left one exchange, in which B. J. Starker got the right to possession of a farm in which an elderly person held a life interest. The court ruled the exchange was valid and tax exempt.
One of the drawbacks of such deals has always been the difficulty of working everything out at the same time. The net effect of the decision is that exchanges need not be simultaneous or almost simultaneous.
The ruling technically affects only the 9th circuit -- the West Coast and Hawaii -- but since it is the first decision of its kind it will undoubtedly be cited in similar cases elsewhere. Delayed exchanges may become another of the many trends California has introduced to the nation.
According to Michael P. Sampson of Washington, who is general counsel to the country's principal organization of real estate exchangors, the Starker decision will be "persuasive but not binding." Other circuit court judges, being notoriously independant, he says, will make their own rulings. One is due next year in the 5th Circuit in Texas.
Because the IRS has lost a number of cases over whether a true exchange took place, Sampson says tax officials have decided to pursue a different policy. They now question the intent, rather than the action, of the owner.
If the IRS can show that the owner initially intended to sell his investment property but accepted an exchange "in lieu of cash," tax exemption will not be granted. The best way to avoid such hassles, Sampson concluded, is to draw up the contract language very carefully.