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01/29/07: Like-Kind (Starker) Exchanges

Housing Counsel

By Benny L. Kass

I’m proud to be paying taxes in the United States. The only thing is – I could be just as proud for half the money.

Arthur Godfrey

Before we get to the subject of this column, there is a news flash from the IRS.

According to an IRS press release, all taxpayers across this country will have until Tuesday, April 17, 2007, to file their tax returns. April 15th –the traditional tax-day – falls on a Sunday, and April 17th is Emancipation Day – which is a legal holiday in the District of Columbia.

So, the IRS filing deadline has been extended for two days. But don’t procrastinate –especially if you plan to receive a refund from the government. Now, back to the subject matter of this column.

You own a single family house which you have been renting for several years. You bought it for $75,000, when you and your spouse just got married, but as your family grew, that house was just too small. Instead of selling, you opted to rent it out.

Now, it is worth $700,000. The tenants have moved out and you do not believe that the property will significantly appreciate much more. You have been advised by your tax accountant that you may have to pay as much as $150,000 in both Federal and State capital gains tax.

What should you do?

One option, of course, is to sell the property, pay the tax, and pocket the rest of the sales proceeds. After all, you made a good decision years ago and clearly renting the property paid off handsomely for you.

Another option is to take back financing, whereby you lend your buyer the money. The buyer signs a promissory note and secures the house with a deed of trust. This is known as an installment sale, and will allow you to spread out the tax payments over the life of the loan. But eventually, you will have to pay the tax.

There is another alternative, namely a like-kind exchange under section 1031 of the Internal Revenue Code. This is commonly referred to as a “Starker exchange”, named after Mr. Starker whose lawsuit confirmed the validity of these transactions.

If you do a proper exchange, you do not have to pay capital gains tax on the property that you have sold – which is called the “relinquished property”. Instead, the tax basis of your former property becomes the tax basis of the new property – which is known as the “replacement property”.

In other words, if the basis of the relinquished property is $75,000, even though the replacement property may cost you one million dollars, the basis of that property will become $75,000.

The theory behind the 1031 exchange is simple: it encourages people to upgrade investment property so that moneys which would otherwise go to the IRS will instead be plowed back into the new investment property. But because the basis remains the same, when the replacement property is ultimately sold (and not involved in yet another 1031 exchange) then the full capital gains tax will be paid.

There are several important rules:

First, both the relinquished and the replacement property must be held for investment purposes.

Second, the properties must be “like-kind”. This is a very broad concept. A single family house can be exchanged for farm land; a condominium unit for an office building, or an apartment building for an office building.

Third, the purchase price of the replacement property must be equal to or greater than the sales price of the relinquished property. Otherwise, a tax on the difference will have to be paid; this is referred to as “boot”.

Fourth, the exchanger cannot have access – for even one minute – to the sales proceeds from the relinquished property. These funds must go into escrow with a qualified intermediary. To quality, that person or company cannot be related to the taxpayer or have been an agent of the taxpayer for the previous two years. For example, if the taxpayer used her attorney for legal services (other than for the 1031 exchange), unless two years have elapsed, that attorney cannot be the intermediary or escrow agent.

Fifth, there are mandatory time restrictions which are spelled out in the law. You have 45 days from the date the relinquished property closed in which to identify to the intermediary the replacement property. This means that you have to be very specific; you cannot say “I want to buy a unit in the ABC condominium”. You must give the exact unit number. You can safely identify up to three replacement properties, and you can ultimately own all of them if you so decide. But you must take title to at least one of the identified properties within 180 days from the date that the relinquished property closed. You have the right to identify any number of properties as long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of all of the relinquished properties.

There are two kinds of 1031 exchanges:

forward: Here, you sell the relinquished property first, and then – following the guidelines described above – obtain the replacement property,.

reverse: often you know that you will sell the relinquished property, but before this is accomplished, you find a desirable property that you would like to use as its replacement. You can reverse the situation, but the rules are quite complex and you must seek professional tax and legal guidance in order to do it properly.

On January 22, 2007, the IRS issued Bulletin 2007-4, which (effective that same date) requires the seller of any real estate to complete a form entitled “Certification for No Information Reporting on the Sale or Exchange of a Principal Residence”. Settlement attorneys and title companies are obligated to get the seller to answer certain questions, and submit the form to the IRS. According to the IRS, “this information is necessary to determine whether the sale or exchange should be reported . . . to the Internal Revenue Service on Form 1099-S.”

Included in the six questions to be answered true or false are:

– I owned and used the residence as my principal residence for periods aggregating 2 years or more during the 5-year period ending on the date of the sale or exchange of the residence.

– during the 5-year period ending on the date of the sale or exchange of the residence, I did not acquire the residence in an exchange to which section 1031 of the Internal Revenue Code applied.

Why this last question?

For many years, there was a loophole in the law. Let’s go back to our example. You bought the property for $75,000 and it will now sell for $700,000. You could do a Starker exchange, rent the replacement property out for a year or two, and then actually move into the house and treat it as your principal residence. At the end of two years, you sell the property and claim the up-to $500,000 exclusion of gain.

Congress closed this loophole a couple of years ago. Now, if you engage in a 1031 exchange, while you can still move into it after a year or two, you cannot claim the exclusion unless you actually owned the property for a full five years.

This is still a good way for investors who are nearing retirement age to obtain replacement property in a location where you want to live in retirement. You rent the property out for a couple of years and then move into it. If you die in that home, your heirs will get the stepped up basis, and will not have to pay the large capital gains tax. If you stay in the property for 5 years, you can claim the exclusion.

How long do you have to rent the replacement property before you can convert it to your principal residence? There is no definitive answer. Many tax attorneys take the position that you have to keep it investment property for at least one full year. The IRS follows what is known as the “old and cold rule” – in other words, if it is held as investment for two years, the IRS will not challenge the facts.

A like-kind 1031 exchange is a potentially beneficial tax arrangement for investors of real estate, but is very complex. You must carefully structure your transaction and make sure that you are following the letter of the IRS laws and regulations.