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1031 Tax Deferred Exchange

Defer Capital Gain Taxes when Buying and Selling homes for sale in Chandler AZ, homes for sale in Gilbert AZ, homes for sale in Phoenix AZ and homes for sale in Mesa AZ with 1031 Tax Exchange (photo)

Starker Delayed Exchanges: Follow The Rules

 

If you sell your home, after having lived there for two out of the past five years before it is sold, our tax laws provide you with a fabulous tax break! You can exclude up to $250,000 of any gain you have made ($500,000 if you are married and file a joint return).

But when you sell rental real estate (called "investment property") you will have to pay the capital gains tax, which for all practical purposes is 15 percent of profit you have made, except those in the top tax bracket who are required to pay 20 percent capital gains rate.

However, there are some creative ways in which to defer -- not avoid -- having to immediately pay any such tax. One such technique is known as a Starker (or "deferred") Exchange, named after Mr. Starker who defeated the Internal Revenue Service, although he had to go all the way to the Supreme Court to win his case.

Currently, the capital gains tax rate is 15% (or 20% for those in the top tax bracket) on the amount of any appreciation and -- depending on facts and circumstances, and how and when you have taken depreciation -- 25 percent recapture on the amount you have depreciated. You have to discuss your specific situation with your own tax adviser. If you sell your investment property and buy another one within the time frames specified by Congress, you have the opportunity to defer -- not avoid -- having to pay any capital gains tax and recapture depreciation for now.

There are many reasons why an income property is sold: to upgrade, downsize, relocate, and diversify your investments are a few. Another is to adjust income stream, enhance tax positions or estate planning. Some people just do not want to continue to be landlords, and you may want to "bite the bullet" and pay the tax. Before you do so, however, you should give serious consideration to the exchange provisions contained in the Internal Revenue Code. They can be a useful device for any knowledgeable real estate investor -- regardless of the size or the value of the property. But, as you will see from this article, you must follow the rules -- and take certain steps before you go to closing to create a paper trail to document your intent to do a 1031 tax deferred exchange.

The law establishing like-kind exchanges can be found in Section 1031 of the Internal Revenue Code. The rules are complex, but here is a general overview of the process.

Section 1031 permits a delay (non-recognition) of gain only if the following conditions are met:

First, the property transferred (called by the IRS the "relinquished property") and the exchange property ("replacement property") must be "property held for productive use in trade, in business or for investment." Neither property in this exchange can be your principal residence, unless you have abandoned the property as your personal house. If you are considering going the 1031 tax deferred exchange route, you should start using the appropriate language found in the IRS regulations.

Second, there must be an exchange; the IRS wants to ensure that a transaction that is called an exchange is not really a sale and a subsequent purchase.

Third, the replacement property must be of "like kind." The courts have given a very broad definition to this concept. As a general rule, all real estate is considered "like kind" with all other real estate providing they are being held for investment purposes. Thus, a farm can be exchanged for a condominium unit, a single-family home for an office building, or raw land for commercial or industrial property or vice versa.

Once you meet these tests, but before you actually move forward with the exchange, it is important that you determine the tax consequences should you just do a straight sale and not an exchange. You must calculate what you will have to pay by way of capital gains tax, and if you are not able to do this, ask your tax accountant to prepare this information for you. If the taxable consequences from a straight sale will not generate a large tax payment to Uncle Sam, you may decide to forego the Starker exchange.

If you do proceed with the like-kind exchange, your profit will be deferred until you sell the replacement property. However, you should understand that the cost basis of the new property in most cases will be the basis of the old property. This is another issue to discuss with your accountant so as to determine whether the savings by using the like-kind exchange will make up for the lower cost basis on your new property.

The traditional, classic exchange (A and B swap properties) rarely works. Not everyone is able to find replacement property before they sell their own property. In the case involving Mr. Starker, the court held that the exchange does not have to be simultaneous. No time limits were imposed on Mr. Starker's exchange.

Congress did not like this open-ended interpretation, and in 1984, two major limitations were imposed on the Starker (non-simultaneous) exchange.

First, the replacement property must be identified on or before the 45th day after the day on which the original (relinquished) property is transferred.

Second, the replacement property (or properties) must be purchased no later than 180 days after the taxpayer transfers his original property, or the due date (with any extension) of the taxpayer's return of the tax imposed for the year in which the transfer is made. These are very important time limitations, which should be noted on your calendar when you first enter into a 1031 exchange. They are mandated by Congress and cannot be extended by even one day.

In 1989, Congress added two additional technical restrictions:

First, property located in the United States cannot be exchanged for property outside the United States.

Second, if property received in a like-kind exchange between related persons is disposed of within two years after the date of the last transfer, the original exchange will not qualify for non-recognition of gain.

In May of 1991, the Internal Revenue Service adopted final regulations which clarified many of the issues.

The Major Points of these regulations are:

1. Identification of the replacement property within 45 days. According to the IRS, 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 properties of any fair market value, (called a "safe harbor") or any number of properties so long as their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of all of the relinquished properties.

Furthermore, the replacement property or properties must be unambiguously described in a written document. According to the IRS, real property must be described by a legal description, street address or distinguishable name (e.g., The Camelot Apartment Building)."

2. Who is the neutral party? Conceptually, the relinquished property is sold, and the sales proceeds are held in escrow by a neutral party, until the replacement property is obtained. Generally, an intermediary or escrow agent is involved in the transaction. In order to make absolutely sure that the taxpayer does not have control or access to these funds during this interim period, the IRS requires that this third party cannot be the taxpayer or a related party. The holder of the escrow account can be an attorney or a broker engaged primarily to facilitate the exchange, although the attorney cannot have represented the taxpayer on other legal matters within two years of the date of the sale of the relinquished property. Select an Exchange Partner financially secure and proficient in 1031 Exchanges so your exchange will not be deemed to have been done improperly and potentially disallowed by the IRS.

3. Interest on the exchange proceeds. One of the underlying concepts of a successful 1031 exchange is the absolute requirement that the sales proceeds not be available to the seller of the relinquished property under any circumstances unless the transactions do not take place.

Generally, the sales proceeds are placed in escrow with a neutral third party. Since these proceeds are used to the purchase the replacement property for up to maximum allowable time of 180 days - (NOT SIX MONTHS), investors usually request an interest bearing account to earn interest on these funds while they sit in the neutral third party account until escrow is ready to close.

The Internal Revenue Service (IRS) permits the taxpayer to earn this interest -- referred to as "growth factor" -- on the escrowed funds. Any such interest to the taxpayer has to be reported as earned income. Once the replacement property is obtained by the exchanger, the interest can either be used for the purchase of that investment property, or paid directly to the exchanger.

There is an interesting loophole which may be attractive to many readers who currently own rental property. Let us assume that you have found your dream house somewhere in the United States where you want to live after retirement. If you sell your investment property, you will have to pay a large capital gains tax. If you do a 1031 tax deferred exchange now, and obtain title to the replacement property where you ultimately want to live when you retire, you can rent out that property until you decide to move. Then, once you have established the new property as your principal residence, if you live in it for at least five years and more than two years have elapsed since you sold your last principal residence, once again you can exclude up to $250,000 (or $500,000 if married and you file jointly) of the gain you have made.

Although the IRS provides no guidance as to how long you have to use the replacement property as an "investment," the general consensus is that you should rent out the property for at least one full tax year.

Thus, depending on the numbers and the facts, you may ultimately be able to avoid the capital gains tax which would normally be due when you sold your Phoenix investment property.

The IRS has also authorized taxpayers to engage in "reverse Starkers," where you buy the replacement property first and then exchange (sell) the relinquished property. It should be noted that quite often, a taxpayer finds the replacement property first, and the owner of that property is unwilling to enter into a long term contract whereby the sale will not take place until after the relinquished property has been sold. According to the IRS regulations, you can reverse the process. Although the basic time limitations are the same for a reverse Starker, the rules are more complex and will end up costing you more money than if you did a regular like-kind exchange.

The rules for the "like-kind" exchange are tricky and a competent and reliable Qualified Intermediary will guide you through the process.

You should also obtain competent, professional financial and legal assistance knowledgeable and experienced in 1031 exchanges before you attempt a 1031 exchange transaction. This is a unique field that most CPA's and Attorneys don't specialize.

Checkout this FAQ related to 1031 Tax Deferred Exchanges.
 

Request a complimentary Free Market Analysis of the value ofyour Phoenix real estate investment property


Contact me before you make a final decision and lets discuss all of your options. I may have some ideas you hadn't thought of yet.

 

My Phoenix Home Seller Guide has other helpful Seller tips and lists additional resources available to assist you with liquidation your Phoenix investment properties and realizing the highest net upon sale.

Or visit my Phoenix Home Buyer Guide for helpful Buyer tips and additional resources developed to assist in the replacement and/or acquisition of your Phoenix investment properties.

 

 

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Sam Elam, Arizona Associate Broker with 25 years of real estate experience
Sam Elam
Associate Broker

480-213-1799
samelam3@msn.com

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