You bought your home many years ago and then bought another home as your personal residence later on. You have been renting the first one for many years. You want to stop being a landlord but your tax accountant has indicated that your gain is over $250,000 and that you will have to pay as high as $40,000 in capital gains tax, plus recapture your depreciation at 25 percent. And depending on your income tax bracket, you may also have to pay the new 3.8 percent Medicare Surtax. There is good news; consider doing a Starker 1031 exchange.

What is a tax-deferred exchange? In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date. Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property is subject to tax.

There are two kinds of deferred (Starker) exchanges:

• forward exchange: you sell the relinquished property, and within the time limitations spelled out in Section 1031, you obtain the replacement property; and
• reverse exchange: you obtain title to the replacement first, and then sell the relinquished property.

The rules are complex, but here is a general overview of the process. With some important exceptions, the rules apply equally whether the exchange is forward or reverse.

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

First, the property transferred (“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 it as your personal house. Your vacation home would also not qualify as investment property unless you actually start to rent it out more or less full time.

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 of this concept. As a general rule, all real estate is considered “like kind” with all other real estate. Thus, a condominium unit can be swapped for an office building, a single-family home for raw land, or a farm for commercial or industrial property.

Here is a general overview of the requirements:

1. Identification of the replacement property within 45 days. Congress did not like the fact that the Starker opinion had no time limitations on when the exchange could take place. Accordingly, the law now requires that the taxpayer identify the replacement property (or properties) no later than 45 days after the relinquished property has been sold.
2. Who is the neutral party? Perhaps the most important requirement of a successful 1031 exchange is that the taxpayer cannot receive (or control) even one penny of the net sales proceeds from the relinquished property. All such proceeds must be held in escrow by a neutral party, and go directly into the purchase of the replacement property. 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 agent 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.
3. Take title within 180 days: The replacement property must be obtained no later than 180 days after the relinquished property is transferred or the due date of the taxpayer’s income tax return for the year in which the transfer is made. If, for example, you transferred the relinquished property on December 1, 2013, your tax return is due on April 15, 2014. That is only 149 days. You either have to obtain the replacement property by that date or get extensions from the IRS so that you can extend out to the full 180 days. The rules are extremely complex. You must seek both legal and tax accounting advice before you enter into any like-kind exchange transaction — whether forward or reverse.

Benefits of exchanging v. selling?

• A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties.
• By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest-free loan from the federal government, in the amount you would have paid in taxes.
• Any gain from depreciation recapture is postponed.
• You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.

General guidelines to follow in order for a taxpayer to defer all the taxable gain?

• The value of the replacement property must be equal to or greater than the value of the relinquished property.
• The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
• The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
• All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.

When can I take money out of the exchange account? Once the money is deposited into an exchange account, funds can only be withdrawn in accordance with the Regulations. The taxpayer cannot receive any money until the exchange is complete. If you want to receive a portion of the proceeds in cash, this must be done before the funds are deposited with the Qualified Intermediary.

Can the replacement property eventually be converted to the taxpayer’s primary residence or a vacation home? Yes, but the holding requirements of Section 1031 must be met prior to changing the primary use of the property. The IRS has no specific regulations on holding periods. However, many experts feel that to be on the safe side, the taxpayer should hold the replacement property for a proper use for a period of at least one year. If the owner, later on, wants to take advantage of the homeowner’s exemption (up to $250,000 or $500,000 for a couple), there is now a five-year holding period requirement.

What is a Qualified Intermediary (QI)? A Qualified Intermediary is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified person.

• Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer.
• The QI holds the sales proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds.
• Finally, the QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.

Why is a Qualified Intermediary needed? The exchange ends the moment the taxpayer has the actual or constructive receipt (i.e. direct or indirect use or control) of the proceeds from the sale of the relinquished property. The use of a QI is a safe harbor established by the Treasury Regulations. If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds. The sale proceeds go directly to the QI, who holds them until they are needed to acquire the replacement property. The QI then delivers the funds directly to the closing agent.

What if the taxpayer cannot identify any replacement property within 45 days, or close on a replacement property before the end of the exchange period? Unfortunately, there are no extensions available. If the taxpayer does not meet the time limits, the exchange will fail and the taxpayer will have to pay any taxes arising from the sale of the relinquished property unless the IRS has expressly granted extensions in specified disaster areas.

Is there any limit to the number of properties that can be identified?
There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules:

• 3-Property Rule: The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or
• 200% Rule: Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property, or
• 95% Rule: The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.

Should you need additional information on a Starker 1031 Exchange, contact us for a detailed report.