Inman News

STARKER "DELAYED"TAX-DEFERRED EXCHANGES BECOME EASIER EVERY DAY. As long-time subscribers know, when I did my first tax-deferred exchange of a three-unit San Francisco building for a nine-unit apartment building, the pre-1984 tax law required simultaneous exchanges of one "like kind" property for another qualifying such property of equal or greater cost and equity. A direct exchange, followed by a "cash out sale" to a waiting third-party buyer for the smaller property, was far better than paying profit tax. But that trade was much more complicated than today's simple Starker exchanges.

Today's Starker "delayed" tax-deferred exchanges are far easier than direct simultaneous exchanges, like my first trade. In the example above, Chevron did a Starker "delayed" exchange of its Disneyland gas station for another property. There is no longer any necessity to do a direct simultaneous exchange (unless the parties happen to want to trade for each other's properties). Chances of that happening are very rare. Here's the story of the first Starker exchange:

Back in the 1970s, T.J. Starker owned some Oregon timberland. Crown-Zellerbach Corp. wanted to buy Starker's land. However, if he sold, he would owe a huge capital gains tax. So he (or his lawyer) created an exchange agreement. Starker deeded his land to C-Z, which then credited Starker with the sales price, plus a 6 percent "growth factor" until he could find suitable replacement "like kind" property to complete what he thought would be a tax-deferred exchange. Guess what' Although Starker reinvested his sales proceeds, plus the growth factor, into such property, the IRS audited Starker and said his so-called exchange didn't qualify for tax deferral because it wasn't a direct exchange. Starker paid the disputed tax (to stop interest from accruing) and then sued the IRS in U.S. District Court for a refund. He won. But the IRS appealed to the Ninth Circuit Court of Appeals. Again, Starker won. Thanks to T.J. Starker's persistence, we now have tax-deferred "delayed" exchanges in Internal Revenue Code '1031(a)(3) which was enacted in 1984. You can read this fascinating 1979 tax case at 602 Fed.2d 1341.

WHY EXCHANGE INSTEAD OF SELLING YOUR INVESTMENT OR BUSINESS PROPERTY' Although tax avoidance is the primary reason for Internal Revenue Code '1031 tax-deferred exchanges, there are many other reasons. First, let's read IRC '1031:

"No gain or loss shall be recognized (that means taxed) on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of a like kind, which is to be held either for productive use in a trade or business or for investment."

There have been hundreds of tax-deferred exchange court decisions interpreting those few words of IRC '1031. Before proceeding, let's look at those ultra-important words "like kind." They do not mean "same kind" of property. "Like kind" simply means all real estate in the exchange must be held for investment or for use in a trade or business. So, you cannot trade your real estate for common stock, limited partnership interests or other non-real estate. Neither can you make a tax-deferred trade of your appreciated common stock, paintings or other personal property for real estate. In summary, keep personal property out of your real estate exchanges!

The only two types of real estate that are not eligible for a tax-deferred exchange are (1) your personal residence, and (2) dealer property, such as a homebuilder's inventory of new homes for sale. The reason is they are not "like kind" realty held for investment or for use in your trade or business. Examples of qualifying exchanges include trading vacant investment land for apartments, a rental house for an office building, a commercial shopping center for several warehouses, and an apartment building for an office building. But you can convert your personal residence to qualify.

Pretend you are a single homeowner whose residence has greatly appreciated in market value since you purchased it many years ago. If you sell, your capital gain will be $400,000, well above the $250,000 principal residence sale tax exemption (up to $500,000 for a married couple filing jointly). Suppose you meet the two-out-of-five-year ownership and occupancy test of Internal Revenue Code '121 to qualify for this great tax break. If you want to sell but not pay tax on that $150,000 capital gain exceeding your $250,000 exemption, you can avoid tax on the entire $400,000 by (1) converting your home into a rental, perhaps on a lease-option with a buyer, and then (2) making a Starker delayed tax-deferred exchange for a "like kind" property, such as apartments, offices or even another rental house, If your goal is to eventually "move up" to a mansion, you can later convert the mansion rental house acquired in a tax-deferred exchange into your personal residence.

How long must a personal residence be rented to qualify for a tax-deferred exchange' In the example above, a personal residence with a big profit was converted into a rental house so it could qualify for a tax-deferred exchange. Your question probably is "How long must the house be rented before exchanging it'" The official IRS answer is "Nobody knows for sure." Surprisingly, there is no IRS regulation on this issue, which is a frequently asked question. Most CPAs and real estate attorneys suggest renting for at least six to 12 months, preferably in two different tax years.

Technically, the minute you move out of your principal residence and convert it into a rental by moving tenants in that property it becomes "like kind" eligible for an exchange. Similarly, when acquiring a rental house, the question often asked is "How long must the house be rented before I can convert it to my personal residence by moving in'" Again, the answer is "Nobody knows for sure." However, if the IRS audits your exchange, the issue becomes "Did you have rental intent when acquiring the replacement rental house, which was later converted into your residence'" Renting six to 12 months should prove rental intent, but there are no guarantees when dealing with the IRS.

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