The far-reaching corporate tax law passed by Congress this month puts a new restriction on tax breaks for investors who obtain property through what is known as a like-kind, or Starker exchange and then convert the property into a principal personal residence.
This topic is complex; understanding it requires some background.
When a real estate investor sells property, and the property has been held for at least one year, the investor owes capital gains tax on the profit. Currently, the federal capital gains tax rate is 15 percent.
However, if the investor wants to purchase other property, there is a way to defer paying the tax. It is called a Section 1031 exchange, like-kind exchange or Starker exchange (named after the investor whose Supreme Court case legitimized such deals).
Under Section 1031 of the Internal Revenue Code, no gain is recognized -- and thus no tax is paid -- if the investor exchanges one piece of real estate for another, and complies with the rules spelled out by the IRS.
Let's say an investor owns a property and wants to get rid of it. This is called the "relinquished property." The property was bought for $100,000, and is now worth $600,000. (For this discussion, we will ignore any depreciation the taxpayer has taken over the years, but depreciation is an important factor in determining gain.) When the property is sold, the investor has a profit of $500,000. At the current capital gains tax rate, the investor would have to pay $75,000 in federal taxes.
However, if the investor decides to do a Starker exchange, the tax will be deferred. The investor must identify a replacement property within 45 days from the date the relinquished property is sold, and must go to settlement on the replacement property within 180 days from the previous sale.
The investor cannot have any access -- or control -- over the relinquished property sales proceeds. They must be held in escrow by a neutral third party, and turned over directly to the title attorney handing the settlement on the replacement property.
If a successful 1031 exchange takes place, the tax basis of the relinquished property becomes the tax basis of the replacement property. Thus, in our example, even if the investor pays $800,000 for the new property, its basis will still be $100,000.
This is called a like-kind exchange, because real property must be exchanged for other real property. You cannot exchange a single-family house for a piece of expensive farm machinery.
However, the definition of real estate is very broad. As long as the replacement property is real estate, the 1031 exchange will work. Thus, a single family house can be exchanged for a farm; an office building for a vacant lot.
Let's look at what Congress has just done.
Say the investor owns a single-family rental house in the city. It has appreciated considerably. The investor plans to retire in two years to Florida. He sells the relinquished house and exchanges it for a replacement property in Tampa. He rents out the Florida house for two years. Upon retirement, he moves into that property and treats it as his principal residence.
Under other provisions of the tax law, specifically section 121(d), if you sell your principal residence, and have lived in it for two out of the five years before it is sold, you can exclude up to $500,000 of gain (if you are married and file a joint tax return) or $250,000 if you file an individual tax return.
Thus, before the recent tax law, the investor could live in the house for two years, sell it and treat it as his principal residence, thereby taking advantage of the above-mentioned exclusions. In other words, there would be situations (depending on the numbers) in which the investor would either avoid paying any capital gains tax, or would have a much smaller tax bill.
The new law imposes a five-year restriction on that loophole. It states: "If a taxpayer acquired property in an exchange in which Section 1031 applied, [Section 121(d)] shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property."
What does this mean? In our example, if the investor did not like his Tampa house and wanted to sell it less than five years from the date of its acquisition, he would not be able to claim the $250,000/$500,000 exclusion of gain. He would have to pay the entire capital gains tax.
That would not be a major catastrophe for investors who want to convert their replacement investment property into a principal residence. It merely puts a five-year waiting period into the equation. It should be noted that the investor can still defer (or even avoid) paying capital gains tax by going the 1031 exchange route.
Say the investor sells the relinquished property. Within the required 180 days, he obtains the replacement property. He must rent it out for at least one year to assure that the process will be considered a valid 1031 exchange. At the end of that year, he has the right to move into the property, and convert it to his principal residence.
What is not clear from the new law is how long after the five-year period the investor has to hold on to the replacement property before he can take advantage of the Section 121(d) exclusions. Can he sell it in the sixth year, or does he have to use and own the property for two years after the new statutory five-year period? I suspect that the Internal Revenue Service will address that issue.
A Starker exchange still makes sense for the many investors who have seen fantastic appreciation in their real estate holdings. And if you ultimately want to convert the replacement property into your principal residence, that option still is available.
It's just that now, under the new law, to take advantage of the exclusions, you will have to wait at least five years before you can sell that property.
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.