Sometimes called a Starker exchange, the 1031 tax deferred exchange is a tool that real estate investors can use to trade properties without incurring taxes on the sale. By following the detailed and arcane rules of Section 1031 of the tax code, as further expanded by the 1979 Starker vs. US court case, investors can avoid paying capital gains and depreciation recapture taxes when they sell their properties.
Simultaneous and Deferred Exchanges
Until the Starker case, every 1031 exchange was a simultaneous exchange. In a simultaneous exchange, you give up ownership of your original property and immediately send the money from that sale to the seller of your new property which you purchase. In a deferred exchange, the money from the sale of the original relinquished property sits in the hands of a third party called a “qualified intermediary” until you are ready to purchase your “replacement” property. Deferred exchanges are the most popular type of 1031 exchange transaction.
The IRS requires that you complete your 1031 exchange within a set time period, and if you miss the deadlines, your exchange will fail and you will have to pay taxes as if you did not exchange. The first deadline is that you must identify which properties you are considering buying within 45 days of your relinquished property’s closing. The second rule is that you must close on the replacement property and perfect the exchange no later than 180 days after the closing of the replacement property.
Property Types and the the Meaning of “Like Kind”
For the 1031 exchange to be valid, you must exchange your property for another property of “like kind.” While like kind rules can be very complicated for personal property exchanges, the standard is relatively simple for investment property. Any piece of investment property in the United States is like kind to any other investment property in the United States. In other words, you could sell a six-unit building in New York City and use the proceeds to buy a timber farm in Oregon or a strip center in Minnesota, as long as they are held as investments and not as personal residences.
When you do a 1031 exchange, the IRS limits how many like-kind properties you can identify during the 45-day period. The most popular rule, the three-property rule, allows you to identify up to three properties of any value with the requirement that you buy at least one of them. The other two rules are the 200 percent rule, which lets you identify as many properties as you want as long as they do not exceed twice the value of the property you sold and the 95 percent rule which also lets you identify as many properties as you want, but requires you to buy at least 95 percent of their total value.
Tax Deferral and Death
To be clear, the 1031 exchange doesn’t completely eliminate capital gains and depreciation recapture tax liability. When you do an exchange, your basis gets carried forward, meaning that you start out owning your new property with your old basis. If you ever sell a property that you 1031 exchanged into without doing an exchange, you would end up paying all of the capital gains and depreciation recapture taxes that you would have paid along the way. You have one way to avoid this unpleasant consequence, though. All that you have to do is to die. When you die, your heirs inherit your property with a stepped up basis equal to its fair market value on the date of your death. This erases any capital gains or recapture tax liability.
written by: Steve Lander
courtesy of: sfgate.com