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Although Congress has reduced the capital gains tax down to 20 percent, no one likes to pay any tax when they sell their investments. If your home is your principal residence, and you have lived there for two out of the past five years before it is sold, you can completely exclude up to $250,000 of any gain you have made ($500,000 if you are married and file a joint return).

But if you sell real estate which you are renting, you will have to pay the capital gains tax -- unless you engage in some creative tax activities. One such procedure is known as a Starker (or "deferred") Exchange, named after Mr. Starker who outwitted the Internal Revenue Service, although he had to go all the way to the Supreme Court to win his case.

Currently, the capital gains tax rate is 20 percent on the amount of any appreciation and 25 percent on the amount you have depreciated. If you sell your investment property and buy another one within the time frames spelled out by Congress, you will defer -- not avoid -- having the pay the capital gains tax now.

Some people just do not want to continue to be landlords, and you may want to "bite the bullet" and pay the tax. But, in my opinion the exchange provisions of the Internal Revenue Code are still an important tool for any real estate investor.

The law establishing this like-kind exchange can be found in Section 1031 of the Internal Revenue Code. The rules are complex, but here is a general overview of the process.

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

  • First, the property transferred (called by the IRS the "relinquished property") and the exchange property ("replacement property") must be "property held for productive use in trade, in business or for investment." Neither properties in this exchange can be your principal residence, unless you have abandoned the property as your personal house.
  • 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 to this concept. As a general rule, all real estate is considered "like kind" with all other real estate. Thus, a farm can be exchanged for a condominium unit, a single family home for an office building, or raw land for commercial or industrial property.

Once you meet these tests, it is important that you determine the tax consequences. If you do a like-kind exchange, your profit will be deferred until you sell the replacement property.

However, you should understand that the cost basis of the new property in most cases will be the basis of the old property. Discuss this with your accountant to determine whether the savings by using the like-kind exchange will make up for the lower cost basis on your new property.

The traditional, classic exchange (A and B swap properties) rarely works. Not everyone is able to find replacement property before they sell their own property. In a case involving Mr. Starker, the court held that the exchange does not have to be simultaneous.

Congress did not like this open-ended interpretation, and in 1984, two major limitations were imposed on the Starker (non-simultaneous) exchange.

  • First, the replacement property must be identified as such before the 45th day after the day on which the original (relinquished) property is transferred.
  • Second, the replacement property must be purchased no later than 180 days after the taxpayer transfers his original property, or the due date (with any extension) of the taxpayer's return of the tax imposed for the year in which the transfer is made. These are very important time limitations, which should be noted on your calendar when you first enter into a 1031 exchange.

In 1989, Congress added two additional technical restrictions.

  • First, property located in the United States cannot be exchanged for property outside the United States.
  • Second, if property received in a like-kind exchange between related persons is disposed of within two years after the date of the last transfer, the original exchange will not qualify for non- recognition of gain.

In May of 1991, the Internal Revenue Service adopted final regulations which clarified many of the issues.

This column cannot analyze all of these regulations. The following, however, will highlight some of the major issues:

  1. Identification of the replacement property within 45 days. According to the IRS, the taxpayer may identify more than one property as replacement property. However, the maximum number of replacement properties that the taxpayer may identify is either three properties of any fair market value, or any number of properties as long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of all of the relinquished properties.

    Furthermore, the replacement property or properties must be unambiguously described in a written document. According to the IRS, real property must be described by a legal description, street address or distinguishable name (e.g., The Camelot Apartment Building)."

  2. Who is the neutral party? Conceptually, the relinquished property is sold, and the sales proceeds are held in escrow by a neutral party, until the replacement property is obtained.

    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, although the attorney cannot have represented the taxpayer on other legal matters within two years of the date of the sale of the relinquished property.

  3. Interest on the exchange proceeds. One of the underlying concepts of a successful 1031 exchange is the absolute requirement that the sales proceeds not be available to the seller of the relinquished property under any circumstances unless the transactions do not take place.

    Generally, the sales proceeds are placed in escrow with a neutral third party. Since these proceeds may not be used for the purchase of the replacement property for up to 180 days, the amount of interest earned can be significant.

    Surprisingly, the Internal Revenue Service permitted the taxpayer to earn interest -- referred to as "growth factor" -- on these escrowed funds. Any such interest to the taxpayer has to be reported as earned income. Once the replacement property is obtained by the exchanger, the interest can either be used for the purchase of that property, or paid directly to the exchanger.

There is an interesting loophole which may be attractive to many readers who currently own rental property.

Let us assume that you have found your dream house in Florida, or in Delaware or anywhere in the United States for that matter. This is where you want to live after retirement.

If you do a 1031 exchange now, and obtain title to the replacement property where you ultimately want to live when you retire, you can rent out that property until you decide to move. Then, once you have established the new property as your principal residence, if you live in it for at least two years -- and more than two years have elapsed since you sold your last principal residence -- once again you can exclude up to $250,000 (or $500,000 if married and you file jointly) of the gain you have made.

Although the IRS has given us no guidance as to how long you have to use the replacement property as "investment" property, the general consensus is that you should rent out the property for at least one complete tax year.

Thus, depending on the numbers and the facts, you may ultimately be able to avoid the capital gains tax which would normally be due when you sold your investment property.

The IRS has also authorized taxpayers to engage in "reverse Starkers", where you buy the replacement property first and then exchange (sell) the relinquished property. This is much more complex, and will have to be the subject of another column.

The rules for a "like-kind" exchange are tricky. You must obtain competent, professional financial and legal assistance if you plan to go this route.

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