Question: About ten years ago, I obtained a house through a Starker Exchange. I rented the property for about three years and since then it has been vacant. However, I have been spending about two months a year there, usually during the summer. We plan to pass this house on to our heirs after we die.
If my heirs sell the house after they inherit it, what impact will the capital gains tax which I deferred in the exchange have on the sale?
Answer: In order to respond, we have to understand the tax consequences of engaging in a Starker (1031) exchange. Let's look at this example. In 1990, you bought property for $50,000. That is called the relinquished property. In 1995, when it was worth $100,000, you exchanged it for your present property (called the replacement property), which was also valued at $100,000. Now, it has been appraised at $400,000.
For this discussion, we will ignore any improvements which you have made, and any commissions or other expenses associated with the property.
Although the cost of the replacement property was $100,000, because it was obtained through a Starker exchange, the tax basis is the same as that of the relinquished property -- or $50,000.
If you sell this property now for $400,000, even though it only cost you $100,000, for tax purposes, you would make a profit (capital gain) of $350,000 (400,000 - 50,000). Current capital gains tax is 15 percent, so you would have to give the IRS $52,500. You may also have to pay a local or state tax on this sale.
A Starker exchange can only be used for investment property. Currently, your replacement property is not investment property, because you are using it personally. However, since you did rent it out for at least the first three years, this would make it qualify for a successful exchange. There is no magic formula -- and no statutory guidance -- as to how long replacement property in a Starker exchange must be held for investment.
The IRS applies what is referred to as the "old and cold" rule -- i.e. properties that have been held for at least two years as investment are "old and cold" and are thus will be considered as "held for investment."
Turning now to your question, there is one simple answer. On your death, your heirs will receive what is known as the "stepped up" basis. The value of the property on the date of your death becomes the new basis of the property. If, on your death, the property is assessed at $500,000, and should your heirs decide to sell the property at that price, they will have no gain -- and thus no capital gains tax to pay.
This obviously is one way to avoid capital gains tax, but is nevertheless a steep price to pay.
