01/19/09: Starker (1031) Exchanges: An Investment Option?
By Benny L. Kass
"The income tax has made more liars out of the American People than golf has"
There is no such thing as a free lunch, but a Starker exchange is about as close as you can get. Contrary to popular conception, it is not a "tax free" exchange, but it does allow you to deter your income tax for a future day.
There is concern in the investment community that the new Obama administration will increase the capital gains tax rate from its current 15 percent to something higher. So now is the time to seriously consider doing that exchange.
Section 1031 of the Internal Revenue Code permits an investor to exchange one property for another, and not have to pay capital gains tax. This is called a "Starker exchange", named after Mr. Starker who years ago won a significant court case which allowed him to obtain the exchanged property several years after he sold his original property.
In order to understand how the exchange works, you have to use the proper vocabulary. Your current property is known as the "relinquished property" and the new property is called the "relinquished property".
The rules are quite simple - but implementation can be tricky. If you do not follow the rules, your exchange will fail and you will have to pay the tax.
When you go to settlement on the relinquished property, all of the net sales proceeds must be put in escrow with a Qualified Intermediary. This can be a professional company, a bank or an attorney who has not represented you within the last two year. Why escrow? You cannot have control of the sales proceeds for even one minute.
From the day you have sold the relinquished property, you have 45 days in which to identify the replacement property. You can identify up to three properties, so long as actually take title to one of them. You have to be specific in your identification; you cannot just say "that house over there on 34th Street, NW.
The law does allow you to identify more than three, but the aggregate fair market value of those properties cannot exceed 200 percent of the aggregate fair market value of the relinquished property.
You must take title to the replacement property within 180 days from the date you went to settlement on the relinquished property. There is one caveat. If your income tax return comes due within the 180 days, you either have to get an automatic extension (by filing form 4868) with the IRS, or complete the transaction. But note that although your tax return can be extended, you still must pay the appropriate tax by April 15, 2009.
Technically, you assign to the intermediary the sales contracts for both the replacement and the relinquished properties. But the IRS allows direct deeding from buyer to seller, so in reality the intermediary is just a formality. But it is a formality that is mandatory.
It sounds easy but there are many complex issues involved:
- what is like-kind : to have a successful 1031 exchange, both properties must be held for investment. And both have to be "like-kind". So long as you are exchanging real property, you should be safe. A condominium can be exchanged for an office building, a farm for a shopping center, or raw land for a single family house.
- Title : the replacement property must be taken in the same way that you held the relinquished property. However, if you owned the former property in your own name, you can take the replacement property in the name of a single member limited liability company. This is considered a "disregarded entity" for tax purposes.
- tax matters: because you defer paying capital gains tax, the tax basis of the relinquished property becomes the tax basis of the replacement property. Even though the later may have cost $500,000, if the basis of the former was only $200,000, that will become the new basis. This is why it is called a "tax deterred exchange". Unless you die - or establish the new property as your principal residence - when you sell the replacement property, you will have to pay the full amount of the tax you deferred, plus on any appreciation on the new property.
- TIC arrangements: in recent years, promoters have created what is known as "fractional ownership". Under this plan, you can use the proceeds from the sale of the relinquished property to obtain a part interest in a property somewhere in the United States, which will qualify as a successful exchange. This is called a "tenants in common" (TIC) ownership.
Alternatively, you can put the proceeds in a Delaware Statutory Trust (DST), where you would have a "beneficial interest" in the Trust for federal income tax purposes.
When you enter into a Starker exchange, you will find many companies promoting their plan. Make sure that you fully understand all of the ramifications of these plans, and talk with your tax and legal advisors before you make any formal commitment.
- vacation homes: in general, a vacation home is not property held for investment and cannot be used in a 1031 exchange. However, in March of last year, the IRS issued Bulletin 2008-10 and announced it would not challenge whether a property was investment if (1) it is owned by the taxpayer for at least 24 months immediately before the exchange, and (2) the taxpayer rents the property at a fair rental for 14 days or more, and (3) the period of the taxpayer's personal use does not exceed the greater of 14 days or ten percent of the number of days that the property was rented for each of the two years referenced above.
I suspect that the IRS will be looking very carefully at exchanges involving vacation homes. While it is now possible, you must have full and complete documentation to prove that you actually rented out your summer home, and did not use it beyond the time limited referenced above.
- reverse exchange: you have found the ideal exchange property but have not yet been able to sell the relinquished property. The IRS has blessed an exchange whereby you obtain title first to the replacement property and then - using the same time limits discussed above - sell your current property. The rules are complex and you must discuss this with a real estate expert.
- tax reporting: if you have engaged in a Starker exchange, you must file form 8824. According to the IRS instructions, "if during the current tax year you transferred property to another party in a like-kind exchange, you must file Form 8824 with your tax return for that year." (Instructions for Form 8824, www.irs.gov/forms and publications).