"When there is an income tax, the just man will pay more and the unjust less on the same amount of income."
You bought your home many years ago, but when the family expanded, you bought another home and have been renting our the first one for many years. You want to stop being a landlord but your tax accountant has indicated that your gain is over $400,000 and that you will have to pay as high as $80,000 in capital gains tax, plus recapture your depreciation at 25 percent. And depending on your income tax bracket, you may also have to pay the new 3.8 percent Medicare Surtax.
Clearly, this is not what you planned when you first bought the house.
There is some good news; consider doing a Starker (section 1031) exchange. If you follow the rules, you can defer any and all tax. The IRS has issued proposed regulations which make it clear that the surtax does not have to be paid if you do an exchange. And although these regulations have not yet been finalized, the IRS has stated that taxpayers may rely on them at least until the final regulations are implemented.
Although often called a "tax-free" exchange, a Starker will not relieve you from the ultimate obligation to pay the capital gains tax. It will, however, allow you to defer paying that tax until you sell your last investment property. At that time, any gain that you have deferred will be built into the new property.
What is a Starker - also referred to as a "like kind" exchange. The ideal exchange is a direct exchange. I own investment property A and you own property B (also investment).. Both are of equal value. On February 1, 2014, you convey B to me and on that same day I convey property A to you. If there is a written agreement between us that this is to be a 1031 exchange, neither of us will have to immediately pay any capital gains tax on any profit we have made.
However, such a transaction is rarely possible. The logistics of finding the replacement property to be exchanged simultaneously with the relinquished property is very difficult, if not impossible to coordinate.
Many years ago, a man by the name of T.J. Starker sold property in Oregon, pursuant to a "land exchange agreement" but did not receive any money for the sale. Instead, the seller -- a couple of years later -- transferred replacement property to Mr. Starker. The Internal Revenue Service considered this a taxable sale, but the 9th Circuit Court of Appeals held that this was a deferred exchange which was permitted under Section 1031 of the Tax Code. In other words, the exchange did not have to take place simultaneously.
There are two kinds of deferred (Starker) exchanges:
- a forward exchange: you sell the relinquished property, and within the time limitations spelled out in Section 1031, you obtain the replacement property; and
- a reverse exchange: you obtain title to the replacement first, and then sell the relinquished property.
The rules are complex, but here is a general overview of the process. With some important exceptions the rules apply equally whether the exchange is forward or reverse:
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 property in this exchange can be your principal residence, unless you have abandoned it as your personal house. Your vacation home would also not qualify as investment property, unless you actually start to rent it out more or less full time.
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 condominium unit can be swapped for an office building, a single family home for raw land, or a farm for commercial or industrial property.
Here is a general overview of the requirements:
1. Identification of the replacement property within 45 days. Congress did not like the fact that the Starker opinion had no time limitations on when the exchange could take place. Accordingly, the law now requires that the taxpayer identify the replacement property (or properties) no later than 45 days after the relinquished property has been sold.
2. Who is the neutral party? Perhaps the most important requirement of a successful 1031 exchange is that the taxpayer can not receive (or control) even one penny of the net sales proceeds from the relinquished property. All such proceeds must be held in escrow by a neutral party, and go directly into the purchase of the replacement property. 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.
3. Take title within 180 days: The replacement property must be obtained no later than 180 days after the relinquished property is transferred or the due date of the taxpayer’s income tax return for the year in which the transfer is made. If, for example, you transferred the relinquished property on December 1, 2013 your tax return is due on April 15, 2014. That is only 149 days. You either have to obtain the replacement property by that date or get extensions from the IRS so that you can extend out to the full 180 days.
The rules are extremely complex. You must seek both legal and tax accounting advice before you enter into any like-kind exchange transaction -- whether forward or reverse.