One of the most talked-about subjects for small real estate investors is the tax-deferred exchange. You hear the term “1031 exchange” or “Starker exchange” from business associates, friends at the ballgame, even parishioners after church.
What exactly is the history of and intent behind this vehicle that enables consumers to defer capital-gains tax on the sale of investment real estate?
This original process is called a 1031 delayed exchange, or Starker exchange. It is named after T.J. Starker, an Oregon man who made a deal with Crown Zellerbach in 1967 to exchange some of his forested property for some “suitable” future property. That agreement ended up in court. Starker’s battle was the basis for congressional approval of delayed exchanges through the Internal Revenue Service.
Section 1031 specifically requires that an exchange take place. The transaction will proceed just as a sale for you, your real estate agent and parties associated with the deal. However, provided you closely follow the exchange rules, the IRS will sanction the transaction and allow you to characterize it as an exchange rather than a sale. Thus, you are permitted to defer paying the capital gains tax.
“The IRS has basically said all along that it will closely scrutinize exchanges without an exchange document and a facilitator in the middle of the exchange,” said Richard Morse, president of Bellevue-based Washington Exchange Services.
“The same is true for reverse exchanges, yet they will be more complex and perhaps more expensive for the person doing the exchange.”
Last week, sparked by consumer questions, we explored reverse exchanges.
Those guidelines permit the title to the new property to be held by an independent third party (typically a facilitator or attorney) until the old property sale closes. Relatively few investors, however, have utilized the reverse exchange.
To totally defer capital-gains tax, you must pass the IRS acid test by:
* Trading even or up in value.
* Trading even or up in equity.
* Not pocketing any cash from the first sale.
* Identifying the new (or old) property, or properties within 45 days of the sale. (Forms are available through a facilitator.)
* Closing the transaction within 180 days.
In an exchange, you must trade an interest in real estate (sole ownership, joint tenancy, tenancy in common) that you have held for trade, business, or investment purposes for another like-kind interest in real estate. The like-kind definition is broad. You can dispose of and acquire any interest in real property other than a home or a second residence. For example, you can trade raw land for income property, a rental house for a multiplex, or a rental house for a retail property.
A house that is the owner’s primary residence cannot be traded for investment property. Nor do stocks, bonds, securities and similar equity investments qualify as like kind. Likewise, if you own land and build a structure on it with 1031 exchange funds, the IRS will probably not consider your investment an exchange.
If the taxpayer receives the proceeds from the disposition of the relinquished property, the transaction will be treated as a sale and not as an exchange. Even if the taxpayer does not actually receive the proceeds from the disposition of the property, the exchange will be disallowed if the taxpayer is considered to have “constructively” received them.
The code regulations provide that income, even though it is not actually reduced to a taxpayer’s possession, is constructively received by the taxpayer if it is credited to his or her account, set apart for him or her or otherwise made available so that he or she may draw upon it at any time.
The day you have to pay your capital gains tax will come eventually unless you leave the property in an instrument such as a charitable remainder trust.
So if you want to sell your investment property, you should weigh the costs of a like-kind exchange against the amount you would have to pay in capital-gains tax if you simply sell the property. Professional facilitators charge about $1,300 to $1,500; private attorneys could cost more.
To find a competent exchange facilitator in your area, consult a real-estate broker, escrow agent, title company or attorney for references. They may be able to help you do a like-kind exchange that allows your retirement nest egg to grow even bigger until the day you really need the cash.
Tom Kelly’s book “How a Second Home Can Be Your Best Investment” was co-written with John Tuccillo, former chief economist for the National Association of Realtors. It is available in bookstores and on amazon.com.
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