Understanding Starker exchange rules

The difference between death and taxes is death doesn't get worse every time Congress meets." --Will Rogers

In this series of tax articles, I have discussed the tax benefits for residential properties, such as the exclusion of gain of up to $500,000, or the various tax deductions available to homeowners.

Now we turn to the tax benefits available to real estate investors.

If you own investment property, and sell it, you will have to pay capital gains tax; for 2007, the tax rate is 15 percent.

But investors are required to depreciate a portion of their property. While this may provide a small tax benefit each and every year, when the property is ultimately sold, in many cases this depreciation must be recaptured at the rate of 25 percent.

Enter the like-kind exchange, which is a way of deferring that tax. At the outset of this column, it must be pointed out that contrary to popular opinion, this is not a "tax-free" transaction. The exchange, authorized by section 1031 of the Internal Revenue Code, will only defer -- not avoid -- the capital gains tax. It will not relieve you from the ultimate obligation to pay the capital gains tax.

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 Starker. The Internal Revenue Service considered this a taxable sale, but the 9th Circuit Court of Appeals held that this was a deferred exchange permitted under Section 1031 of the Tax Code. In other words, the exchange did not have to take place simultaneously.

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 Aug. 1, 2007, 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.

But it is almost impossible to arrange such a transaction. The logistics of finding the replacement property to be exchanged simultaneously with the relinquished property is very difficult to coordinate.

Accordingly, most 1031 exchanges today are deferred.

There are two kinds of deferred (Starker) exchanges:



Forward exchange: You sell the relinquished property, and within the time limitations spelled out in Section 1031, obtain the replacement property;




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 (discussed below) 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:

Must be investment property: The property transferred (called 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.

The area of vacation homes is complex and often misunderstood by taxpayers and lawyers alike. The IRS recently promised to provide more information to taxpayers regarding the treatment of these vacation homes.

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. Practically, an exchange looks like a sale, but the paperwork involved with the transaction makes it an exchange. It is important that anyone considering a 1031 exchange retain counsel who is familiar with the various rules.

The replacement property must be of "like kind": 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.

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, it must be noted 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 a like-kind exchange will make up for the lower cost basis on your new property. Many taxpayers are excited about the concept of deferring their gain, but when they analyze their situation, they realize that the tax will only be a few thousand dollars. Additionally, becoming a landlord again may not be that attractive.

There are two important time limitations that are spelled out in the statute and cannot be waived or modified:

1. Identification of the replacement property within 45 days. Congress did not like the fact that Mr. Starker had no time limitations on when the exchange could take place. Accordingly, the law now requires that the taxpayer identify the replacement property no later than 45 days after the relinquished property has been sold. 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 percent of the aggregate fair market value of all of the relinquished properties.

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 Nathan Apartment Building).

2. A neutral party is essential. If the taxpayer has any control of even one penny of the relinquished property's sales proceeds -- even for one minute -- the exchange will fail. All such proceeds must be held in escrow by a neutral party until the taxpayer is ready to close on the replacement property. At that time, the funds must go directly into that purchase. 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 a broker or an attorney, unless the attorney had within the past two years represented the taxpayer. In such cases, the IRS takes the position that the client controls the attorney and the funds would be constructively in the hands of the taxpayer.

3. Take title within 180 days: Title to the replacement property must be obtained no later than the earlier of 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 Dec. 1, 2007, your tax return is due on April 15, 2008, which is only 136 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. Nowadays, getting an extension is automatic. If by the due date, you file Form 4868, you will get an extension for six months. Please note, however, that while this allows you to late file your tax return, you still have to pay the tax by April 15, 2008.

4. Interest on the exchange proceeds.

What happens to the interest earned while the sales proceeds are held in escrow? The IRS calls this the "growth factor," and 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.

Reverse exchanges: It is often difficult to meet the 45/180-day requirements. You have found the replacement property, but do not yet have a buyer for your relinquished property. And the owner of the new property is not prepared to wait until you are able to go to closing on your current property.

The reverse Starker -- if done properly -- can solve this dilemma. Here are some of the important rules:

1. The taxpayer must arrange for the replacement property to be held in a "qualified exchange accommodation arrangement." In government language, this is called "QEAA."

2. Qualified indicia of ownership of the property by the QEAA is required. This means that the QEAA must either have legal title to the replacement property or some other arrangement that is acceptable to the IRS to demonstrate ownership. For example, a land sales contract (also called "contract for deed") may suffice. Under this latter arrangement, the QEAA will not have actual legal title, but will have contractual obligations. This may -- depending on state or local law -- avoid having to pay a double recordation-transfer tax. Otherwise, this tax must be paid when the property is first transferred to the QEAA and then again when it is transferred to the ultimate taxpayer.

3. No later than five business days after the property is transferred to the QEAA, the taxpayer and the exchange accommodation titleholder (called the QEAT) must enter into a written agreement that states that the latter is holding the property for the benefit of the taxpayer in order to facilitate an exchange under section 1031. Generally, this can be accomplished by a lease of the property from the QEAT to the taxpayer.

4. Both the taxpayer and the exchange accommodation titleholder (the QEAA) must file separate federal income tax returns, so as to advise the IRS of any income and expense incurred while the QEAT had ownership of the property.

5. No later than 45 days after the replacement property is transferred, the taxpayer must identify the relinquished property. The IRS allows the taxpayer to identify alternative and multiple properties, and if the taxpayer owns several investment properties, this provides some flexibility as to which property will be sold.

6. No later than 180 days after the replacement property is transferred to the QEAT, it must be conveyed to the taxpayer.

7. Perhaps the most important aspect of a reverse Starker is the requirement that the taxpayer have a legitimate desire to engage in a 1031 exchange. According to the IRS regulations:

At the time the qualified indicia of ownership of the property is transferred to the exchange accommodation titleholder, it is the taxpayer's bona fide intent that the property held by the exchange accommodation titleholder represents ... replacement property ... in an exchange that is intended to qualify for non-recognition of gain (in whole or in part) or loss under §1031.

In other words, you cannot buy the replacement property and then -- as an afterthought -- decide to treat the transaction as a 1031 exchange.

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.

Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to benny@inman.com.

When can my rental become my dream home

Clearing up confusion over 1031 property exchanges


By Benny L. Kass
Inman News

DEAR BENNY: In a recent column, I read that 1031 property transfers had to be held for a period of one to two years to establish "intent." I thought that a law was passed in October 2004 that stated the "intent" period was five years. I bought a 1031 property in California in 2005 and would appreciate this being clarified. Thank you for column! --Nancy M.

DEAR NANCY: The column was correct and so are you -- but you both are referring to different aspects of a 1031 (often called a "Starker") exchange.

Issue #1: Here, too, there are two issues: (a) How long can you hold the replacement property before you can exchange it again? and (b) How long do you have to keep the property as investment before you can move into the property and treat it as your principal residence?

As for (a), the statute clearly says that in order to get non-recognition of gain, you have to keep it for at least two years. As to (b), as that recent column properly stated, there is absolutely no IRS official guidance. Some tax lawyers take the position that one year and one day (i.e. go through one tax year) is sufficient. Others rely on what we call the "old and cold rule," namely that if the transaction took place more than two years ago, the exchange will generally not be reviewed by the IRS.

I have lots of clients who exchanged their investment rental property for a retirement home in Florida or Nevada, and want to know how long they must rent it before they can move in and establish it as their principal residence. The safe harbor is two years.

Issue #2: That leads us into the second part of your question. You are correct in that Congress a couple of years ago made some changes to 1031 exchanges. If you do an exchange and then convert it to your principal residence, in order to take advantage of the up-to-$250,000 exclusion of gain ($500,000 if you are married and file a joint tax return), you have to own the property for a full five years before it is sold. You also have to meet the two-year occupancy requirement. The actual text of the law reads as follows:

PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE -- If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the five-year period beginning with the date of the acquisition of such property.

I hope this clarifies the confusion.

DEAR BENNY: My wife and I and another couple are in the middle of buying a condo together and should be closing this month. The other couple has already been preapproved for 100 percent financing. We've been told that since they are already approved that they should go ahead and buy the condo and then amend the title while we're in escrow and add my wife and I to the title. I was curious as to whether this would work. --Josh

DEAR JOSH: I don't think so. Your friends have been approved for a loan, but you have not. At closing (you call it escrow) the lender will give specific instructions that will include that your friends will have to sign the promissory note and deed of trust. I seriously doubt that the escrow company will permit you and your wife to be added without the approval of the lender.

Can you qualify for the loan? Have you discussed the situation with the lender? The lender may also want to consider this an investment loan, which could result in an increase in the mortgage. Your friends could, of course, add your name to the title after escrow, but that might be grounds for the lender to call the loan based on the "due on sale" clause that I am sure will be in their deed of trust (the mortgage document).

So, I suggest that you talk to the lender and see what can be done between now and the escrow date.

But, your question raised two additional issues that concern me. First, you state that the loan is 100 percent. I don't know your financial situation (or that of your friend) but such loans have recently been associated with the many foreclosures that are taking place throughout the country. Have you -- or your friend -- carefully examined the terms of that loan? At some point, that loan will change whereby you will have to start paying principal and interest -- but at what interest rate? I am not a fan of such 100 percent loans.

Of equal importance, do the four of you have a written agreement as to how you will handle the property? What if you and your wife want out of the deal? What if someone dies? What if one of the partners gets divorced? What if someone cannot pay his or her share of the monthly mortgage payments?

All of these issues must be reduced to a written partnership agreement. The time to resolve these issues is when you are talking to each other.

DEAR BENNY: My wife and I are considering helping our son buy his first house. He is a recent college graduate with a well-paying professional job. He has been working for about a year, with about four months in his current job. He is living in our home paying some rent while saving the bulk of his paycheck. Given the cost of homes in the area and his lack of credit history, my wife and I figure he would need our help to buy his own home. Do you have any suggestions on how to approach this situation? We are not crazy about the idea of co-signing, as we consider that a risky proposition, but would be more amenable to co-ownership. Even if we agree to co-ownership, how can we protect our interest if the property is not maintained properly? Any tax consequences for us? --Steve

DEAR STEVE: Good question and very timely. As you suggest, property values nowadays are out of reach for many young adults.

There are several ways to approach this. First, do you have the money to buy the house and then rent it to your son? Every year, you and your wife could gift him up to $24,000 of the value of the house (you can gift up to $12,000 per person tax- and gift-tax free). You will need an attorney to assist you with this arrangement.

Next, can you be the bank? Can you lend him all the money and take back financing? He would pay you a fixed interest rate, which could even be greater than you are currently getting from your investments.

Finally, you could enter into what is known as a "shared-equity" arrangement. For example, you and your wife would own 50 percent of the property and your son would own the other half. You have to discuss with your attorney how title will be taken. But with a shared-equity arrangement, you both pay your share of the mortgage, taxes and insurance, and your son pays you rent for the half of the house that you own.

You need a written agreement, which will spell out all of the terms and conditions regarding the property. You asked about maintaining the property; the agreement will include provisions that should give you the protection you need.

There are two benefits for a shared-equity arrangement. Many lenders will give you a loan based on a personal residence rather than as an investment loan. Thus, you would get the benefit of a lower interest rate. Second, while you would have to pay tax on the rental income you receive from your son, you will also be able to deduct for tax purposes your share of the mortgage interest and real estate tax. You should also be able to take depreciation on the portion of the property that you rent to your son.

DEAR BENNY: What is a "hard-money lender"? I have read that they are entities that lend money out at 10 to 12 percent interest. They stay in business because the people who borrow their money will pay the higher interest to get the money faster and without a credit check.

Do people who buy at foreclosure sales or get involved with short sales use this as a means of financing these properties? Where do I find these "hard-money lenders"? --John

DEAR JOHN: There are good and bad hard-money lenders. These lenders usually make short-term, high-interest loans, and often they are "bridge loans.. For example, you want to buy a new house but have not yet been able to sell your current one. You have sufficient equity in your house, so you borrow money using your house as collateral. You hope that your house will sell quickly and thus are not concerned that the interest rate is higher than you can get from a commercial lender.

Usually, these hard-money lenders rely on the equity in your house rather than on your financial ability to pay.

But that's where problems start. Too many lenders make such loans knowing that the borrower will not be able to make the monthly payments, and thus the lender will ultimately foreclose on the property. In effect, these loans are designed to fail. They are called "predatory lenders."

You can find hard-money lenders just by typing those words in your favorite Internet search engine. But they should be the "lender of last resort." If you have to rely on a high-interest, short-term loan, maybe you are not ready to make that purchase.