I own investment property and intend to sell it shortly. I have been advised by my accountant that the capital gains tax is no longer applicable, and that I will have to treat the profit I will be making as ordinary income. This will cost me a lot of money, and I have heard that others are using a tax-free exchange of property, which I understand is called a "Starker exchange." Can you give me some guidance on this issue?
It is difficult to try to understand all of the complex ramifications of the Internal Revenue Code affecting residential real estate issues when the owner of the property uses it as a principal residence. When you go into the investment arena, the tax laws are not only complicated, but if you make the wrong decision, you will end up with a serious tax exposure. Thus, you must discuss the issues with your tax adviser.
Years ago, Congress enacted Section 1031 of the Internal Revenue Service Code. The language of reads as follows:
"No gain or loss shall be recognized if property held for productive use in trade or business or for investment ... is exchanged solely for property of a like kind to be held either for productive use and trade or business or for investment ... "
In effect, that statute permits nonrecognition of gain only if the following conditions are met:
First, the property transferred and the property received by the taxpayer must be "property held for productive use in trade or business or for investment." Second, there must be an "exchange." Third, the properties exchanged must be of "like kind." The courts have given widespread interpretation in defining what is a like-kind exchange, but you should be cautioned that Congress is giving thought now to putting limitations on the kinds of exchanges permitted under Section 1031.
Once you meet these tests, you then have to determine what the tax consequences are. If you do a traditional like-kind exchange, the profit you will have made on the first property will be deferred until you finally sell the exchange property. However, the cost basis of the new property will be the basis of the old property transferred without the recognition of gain. You must discuss this with your accountant to determine whether the savings to you by the like-kind exchange will make up for the lower cost basis on your new property. What this means is that although you will be able to depreciate the new property under the terms of the Tax Reform Act of 1986, the basis of the depreciation may be what you paid for the first property in the first place, less any depreciation you may already have taken.
I suspect that since Congress has now eliminated the capital gains tax, which until January 1987 imposed a tax of no more than 20 percent of the gain, more and more investors will begin looking at the like-kind exchange concept under Section 1031 of the Internal Revenue Code. It should be pointed out that this year there is a maximum tax of 28 percent tax on the gain. Next year, any gain from the sale of real estate will be taxed at whatever your ordinary income rates will be.
However, not everyone is able to find a like-kind property to be exchanged before he or she sells investment property. In a case involving a man by the name of Starker, the tax court held that the exchange does not have to be simultaneous. Under the Starker case, the court held that "simultaneity of transfer" is not a requirement of nonrecognition under the tax code. Starker sold property and some time later purchased new property, and then successfully claimed that this was a "sale and exchange."
Congress was concerned about the expansion of the like-kind exchange concept. When it passed the tax reform act of 1984, it put two major limitations on the Starker (nonsimultaneous) exchange. First, the property to be received by the taxpayer (your new property) must be identified as such before the 45th day after the date on which the property is transferred.
Second, the new property must be received no later than 180 days after the taxpayer transfers his original property, or the due date with extension of the taxpayer's return for the year the transfer is made.
Benny L. Kass is a Washington attorney. For a free copy of the ooklet "A Guide to Settlement on Your New Home," send a self-addressed, stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.