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No one likes to pay tax on a real estate sale. But if you sell investment property, you will have to pay the capital gains tax unless you engage in some creative, but completely legal, tax accounting.
One such procedure is known as a Starker, or "deferred," exchange, named after property owner T.J. Starker, who won a Supreme Court case in 1979. The case established a basic principle: If you exchange one property for another, even if the replacement property is purchased later, under section 1031 of the Internal Revenue Code you do not have to pay tax on the sale. Instead, the basis of the relinquished property becomes the basis of the replacement property.
Congress did not like that several years had elapsed between the time Starker sold the relinquished property and the time he obtained the replacement property. So it set strict time limits for Starker exchanges. You must identify the replacement property, or properties, within 45 days of the date you sell the relinquished property, and you must take title to that property within 180 days of the sale.
The capital gains tax rate is 20 percent of any appreciation and 25 percent of the amount you have depreciated. If you sell your investment property and buy another one within the time limit specified in the law, you will defer the capital gains tax but not avoid paying it later.
Some people just do not want to continue to be landlords, and may want to pay the tax rather than continuing to own real estate. But in my opinion, the exchange provisions of the Internal Revenue Code are important tools for any real estate investor.
Section 1031 of the Internal Revenue Code permits a delay (non-recognition) of gain only under following conditions:
* The relinquished property transferred and the replacement property must be "property held for productive use in trade, in business or for investment." Neither property in an exchange can be your principal residence.
* There must be an exchange. The Internal Revenue Service wants to be sure that a transaction called an exchange is not really a sale and a subsequent purchase.
* The replacement property must be of "like kind." The courts have given a very broad definition to that term. As a general rule, all real estate is considered "like kind" with all other real estate. Thus, a farm can be exchanged for a condominium unit, a single-family house for an office building, or raw land for commercial or industrial property.
In 1989, Congress added two technical restrictions:
* Property in the United States cannot be exchanged for property in another country.
* If property received in a like-kind exchange between related people is disposed of within two years after the last transfer, the original exchange will not qualify for non-recognition of gain.
Once you meet these tests, it is important that you determine the tax consequences. If you perform a like-kind exchange, your profit will be deferred until you sell the replacement property. However, because the cost basis of the new property in most cases will be the basis of the old property, you should review the situation with your accountant to determine whether the savings you get by using the like-kind exchange would make up for the lower cost basis on your new property.
The classic exchange (A and B swap properties) rarely works. Not everyone is able to find replacement property before they sell their own. In T.J. Starker's case, the court held that the exchange does not have to be simultaneous. But the time limits are important and should be noted on your calendar when you enter into a 1031 exchange.
In 1991, the IRS adopted regulations that clarified many of the issues. Among them:
* Identification of the replacement property within 45 days. The taxpayer may identify more than one property as replacement property. However, the maximum number of replacement properties that the taxpayer may identify is either three of any fair market value, or any number of properties as long as their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of all of the relinquished properties.
The replacement property or properties must be unambiguously described in a written document by a legal description, street address or distinguishable name.
* Choice of a neutral party. When the relinquished property is sold, the sales proceeds are held in escrow by a neutral party until the replacement property is obtained. Usually, an intermediary or escrow agent is involved in the transaction. To make sure that the taxpayer does not have control of or access to the proceeds during the interim, the IRS requires that the intermediary or agent cannot be the taxpayer or a related party. The holder of the escrow account can be a lawyer or broker engaged primarily to facilitate the exchange, although the lawyer cannot have represented the taxpayer on other legal matters within two years of the date of the sale of the relinquished property.
* Interest on the exchange proceeds. A successful 1031 exchange requires that the sales proceeds not be available to the seller of the relinquished property under any circumstances unless the transactions do not take place.
Since the proceeds may not be used for the purchase of the replacement property for as long as 180 days, the interest earned can be significant.
The Internal Revenue Service permits the taxpayer to earn interest on the money in escrow. Any such interest must be reported as earned income. Once a replacement property is obtained, the interest can either be used for the purchase of that property, or paid directly to the exchanger.
There is an interesting loophole that might be attractive to many people who own rental property.
Assume that you have found your dream house where you want to live after you retire.
If you do a 1031 exchange now, and obtain title to the property where you want to live in retirement, you can rent out that property until you decide to move. After you have established the new property as your principal residence and have lived in it for at least two years (and more than two years have elapsed since you sold your last principal residence) you can sell it and exclude up to $250,000 (or $500,000 if married and you file jointly) of the gain you have made.
Although the IRS has not said how long you must use the replacement property as "investment" property, the general consensus is that you should rent out the property for at least one complete tax year.
Thus, depending on the numbers and the facts, you may be able to avoid the capital gains tax that would normally be due when you sell your investment property.
The IRS has also authorized taxpayers to engage in "reverse Starkers," in which you buy the replacement property first and then sell the relinquished property. This is much more complex, and you should get specific guidance from your tax adviser.
For any Starker exchange, it's important that you follow the rules precisely. You must obtain competent financial and legal assistance if you plan to go this route.
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, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.