"We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle"
- Winston Churchill
If you are an investor and plan to sell your house this year, you should give serious thought to doing a Starker exchange. Under section 1031 of the Internal Revenue Code, if you follow the rules and swap one investment property for another, you will defer any tax which would otherwise have to be paid.
And as of this year, those taxes can be quite hefty. Take this example: you are married, and your income is between $250,000 and $450,000. You have had good appreciation on that house you bought back in 1985, and you anticipate a profit of some $500,000. If you sell the house this year, in addition to having to recapture what you have depreciated in the past, you will have to pay capital gains tax of 15 cent, and also the medicare surtax of 3.8 percent plus any applicable state and local tax. And if your income is over $450,000, the capital gains tax will increase to 20 percent.
If you conduct a proper 1031 exchange, no gain will be recognized and thus you will not have to pay any capital gains tax. The IRS has just issued proposed regulations interpreting and explaining how the new medicare surtax works. One sentence in that proposal reads: "to the extent that gain from a like-kind exchange is not recognized for income tax purposes under Section 1031, it is not recognized for purposes of determining net investment income under Section 1411." In other words, if you do a 1031 exchange, you will not have to pay the 3.8 medicare surtax. The regulations may not become finalized until later this year, but in the meantime, if you are considering selling your investment property, you have the right to rely on this language.
The simplest exchange involves a direct swap: I own house "A" and you own property "B". At settlement, I give you a deed to my property - called the "relinquished property" in exchange for a deed to your house. (which is called the "replacement property") However, the logistics involved make this approach almost impossible to achieve.
Thus, we look to a Starker exchange. Many years ago, Mr. Starker sold a large tract of Oregon land and told the buyer to keep the money until such time as he found a replacement property. A couple of years later, Mr. Starker bought the replacement property, and the money went directly from his buyer to the new seller. Mr. Starker took the position that under section 1031 he did not have to pay any capital gains tax; the IRS disagreed. However, the ninth circuit court of appeals agreed with Mr. Starker and thus the Starker exchange became law.
Congress was not happy with the length of time involved in that case, so it narrowed down the time frames. As the law is today, you have 45 days from the date you sell the "relinquished" property to identify the "replacement" property (or properties"). Then, within 180 days from the date of sale, you must take title to the replacement property. If your tax return for the year the property is sold comes due before the 180 days, you must either obtain an extension from the IRS or close before the April 15th date.
The question is always asked: "where is the exchange? This just looks like I sold house A and bought house B."
Yes, it does look like that. There have been numerous cases where the courts were faced with the question: was this a sale or an exchange? Typically, there are two important factors that the courts look to: first, what was the intention of the taxpayer? Did he always intend to engage in a 1031 exchange or was this an afterthought? That is why it is important for the seller to include language such as this in the contract to sell as well as the contract to buy: "the parties understand that this is part of a section 1031 exchange and agree to cooperate with each other".
Second, did the seller have control over the sales proceeds? Typically, the sales proceeds are held by an intermediary, selected by the seller. When the exchangor goes to closing on the replacement property, the sales proceeds go directly to the seller. If the exchangor has any control over those funds - even for one minute - the exchange will fail.
A 1031 exchange involves investment property; it is not available for your principal residence. It also requires that the properties being exchanged are "like-kind". This means that any real estate can be exchanged for other real estate. For example, a farm can be swapped for a condominium unit; an office building can be exchanged for raw land. However, your vacation home is not considered "investment" property if you have, in fact, made personal use of it.
A 1031 (Starker) exchange may make sense, but keep in mind that you will be back in the landlord-tenant arena once again. Keep in mind also that the tax basis of the replacement property is the basis of the relinquished property. In other words, if the house you sold has a tax basis of $200,000, even if you paid $1 million dollars for the new house, its basis will be $200,000. That is why a Starker exchange cannot be called a "tax-free" transaction. If you ultimately sold the replacement property and did not do another exchange, you will have a lot of capital gains tax to pay.
If you are considering the exchange, talk to your accountant or financial advisor first. You may not have as much gain as you thought and it may not be worth your while to spend the time and money involved in the process. Locating the replacement property within 45 days is often difficult and these deadlines are carved in stone; they cannot be modified or extended.
Some investors would prefer just to pay the tax and enjoy whatever money is left. This is a personal decision, which can only be made by you.