Starker 1031 Exchange
This works sometimes for some owners. I am an intermediary and not qualified to give out tax, law or legal advice. Consult with the Internal Revenue Service, a competent tax attorney or accountant.
There is only one way to sell your investment or business real estate, such as rental property or vacant land, without owing tax on your profit. It is a tax-deferred exchange. Fortunately, Uncle Sam has made it downright easy to do so, thanks to his Starker delayed tax-deferred exchange rules. Internal Revenue Code 1031(a)(3) now lets investment and business property owners sell their old property and then use the proceeds to buy qualifying replacement property. However, personal residences are not eligible.
What is a tax-deferred exchange? For tax purposes, a qualifying tax-deferred real estate exchange is viewed as one continuous property holding. The major advantage is that there is no tax erosion of profits while disposing of one property and acquiring a replacement. For example, I had a customer that made a tax-deferred exchange of their apartment building, located about an hour away from their home, to one 15 minutes way. They reinvested all their profits into the acquired property, so no profit tax was due. More important, their acquired building offers more profit potential as they fix it up and raise the rents.
What is a Starker delayed tax-deferred exchange? A direct trade of one property for another is no longer required to qualify for tax-deferral. A delayed trade is called a Starker delayed tax-deferred exchange (named after T.J. Starker, the first taxpayer to make such a trade).
Here is how it works: My customer Norris first sold his old apartment building. He had the sales proceeds held by a third-party intermediary accommodator. If he had access to or received the cash, called "constructive receipt," his tax-deferred exchange would have failed. After the sale, Norris had up to 45 days to designate the replacement property to be acquired. His purchase offer for that property was accepted. He then told the accommodator to buy the nearby apartment building with the cash from the sale of his old property. He could have taken up to 180 days to complete the acquisition. It is that simple.
The top 10 reasons to exchange. Tax avoidance is the number one reason owners of apartments, rental houses, stores, warehouses, offices, farms and vacant land held for investment or business use want to exchange.
Additional reasons include: (2) getting rid of an undesirable property and acquire a more desirable one; (3) disposing of a hard-to-sell property and acquiring one that is easier to sell; (4) changing locations; (5) switching from one type of property to another; (6) acquiring a property that requires less management; (7) acquiring a property with better cash flow; (8) pyramiding one’s wealth into a large estate without paying profit tax when trading up; (9) increasing depreciable basis; and (10) receiving tax-free mortgage refinance cash either before or after (but not during) the trade.
The basic exchange rules. There is no limit to the number of qualifying "like kind" properties in a tax-deferred exchange. For example, you can trade your two rental houses for a commercial building. Or you can trade your warehouse for three rental houses. Remember, your personal residence cannot be part of a tax-deferred exchange. All properties in the exchange must be "like kind," meaning held for investment or use in a trade or business.
The basic exchange rules are: (1) Trade equal or up in market value; (2) do not take any "boot" (personal property), such as cash or net mortgage relief out of the exchange,; and (3) follow the simple tax-deferred exchange rules, especially for a Starker delayed tax-deferred exchange.
The three types of tax-deferred exchanges. With slight variations, there are only three types of qualifying tax-deferred exchanges. One is the direct exchange of one property for another. This occurs very rarely, because the up-trader usually wants a larger property, but the down-trader rarely wants the smaller property the up- trader has to offer.
The second type of exchange is a simultaneous three-way exchange. This was the first type of exchange I participated in, almost 12 years ago. I had listed a six-unit apartment building to someone wanting to move up and exchanged him into an eighteen unit building. It was tax-deferred for the six unit owner because he was trading up without taking out any "boot." But it was taxable for the eighteen unit down-trader, who immediately sold the six units to a prearranged "stand-by cash buyer" that I had waiting. Getting three parties all in agreement all at the same time was the most difficult part!
The third type of tax-deferred exchange is the Starker delayed exchange. This is, by far, the most popular type of trade today. It is really a property sale followed by a property purchase. Just remember to keep the sales proceeds beyond your "constructive receipt."
A questionable fourth type of exchange, called the "reverse exchange," has not yet been officially sanctioned by the IRS, but it does occur. It involves acquisition of a replacement property (usually by a third-party intermediary) before the old property is sold.
How to trade your home for income property, or vice versa. As explained earlier, only property held for investment or use in a trade or business can qualify for a tax-deferred exchange. Personal residences are not directly eligible.
However, many owners of investment or business properties want to make tax-deferred exchanges for a personal residence, often a luxury home. Or personal residence sellers want to avoid investment or business property, without paying profit tax. This cannot be accomplished directly.
One way to achieve this tax-deferred result is to trade an apartment building for a rental house, following the exchange rules. The acquired rental house should probably be rented at least a year before converting it to your personal residence.
Homeowners who would have more than $250,000 in profits if they sell (or $500,000 for a married couple filing jointly) can do just the opposite. They can move out, rent their house — most CPAs recommend at least a year — and then make a tax-deferred exchange for investment or business property.
"Tax evasion is illegal. Tax avoidance is legal and commendable."
Seek qualified advice from a competent tax attorney
or accountant.
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