IRS Section 1031 Starker Exchanges
Defer Capital Gains and Build Wealth
“Buy land, they’re not making it anymore.” – Mark Twain, writer and humorist.
So obvious and yet so brilliant, Twain was onto something all those years ago. Whether your interest is the land or the structures on it, investing in real estate has long been seen as a fundamental method for building wealth. But not for the impatient. Much like your retirement accounts, investing in real estate can take a lifetime and there are no shortcuts. Surrounding yourself with a small group of trusted advisors who are focused on your long-term success to make sure you are taking advantage of every tool available as you navigate this long path is key.
the history of a 1031 starker exchange
One such tool to promote investment in real estate is IRS Section 1031, colloquially known as a Starker exchange or 1031 exchange, which allows investors to defer capital gains into the future by transferring these gains from an investment property sale into a new/replacement asset(s). Initially carved into the Revenue Act of 1921, the nuances of the Starker exchange have and continue to change most recently with the Tax Cuts and Jobs Act of 2017, which limited 1031 strategies to real estate defined as land, structures and improvements.
Tax history can be dry, but the family for which this legislation is named spurned decades-long litigation on the issue of tax-deferred like-kind exchange. T.J. and son Bruce Starker sold timber to a company in exchange for a promise to acquire and transfer title to properties in the family’s name within a set period of time. The IRS contended that such a delayed exchange did not qualify for deferral of income tax liabilities (known as non-recognition treatment) and set the precedent for non-simultaneous delayed tax-deferred like-kind exchange transactions.
The Starker family case demonstrated to the investment community that non-simultaneous, delayed tax-deferred like-kind exchanges will qualify for non-recognition treatment and provides flexibility in the structuring of tax-deferred like-kind exchange transactions. Quite a mouthful we know – and the rules for these types of transactions are far from simple.
What is the theory behind a starker exchange?
An investor generally observes a holding period for an asset with the goal of that asset being that it will grow in worth in the future. The future sale of this higher value asset will trigger capital gain taxes. When the asset is sold, this higher-valued asset will incur substantial pre-tax profits and a risk for taxable gain for the investor. To alleviate this threat, a Starker exchange, if handled correctly, can result in tax deferment.
How is deferring your tax beneficial? For the same reason a 401k exists, to allow for tax free growth of an asset. What’s more, there is effectively no limit on how many times or how frequently this transaction can occur. This allows the asset to roll over the gain from one property investment to another and defer taxes of capital gains into some future point in time upon the end-sale or liquidation of the final asset.
so how do I defer my payments?
The IRS considers any investment of real estate “like-kind,” a vague description which allows for a wide range of property types to be exchanged. Vacant land can be exchanged for a commercial building, for example, or industrial property can be exchanged for residential or multi-family. You cannot exchange real estate for artwork, for example, as that does not meet the definition of like-kind. Property must be held for investment, not resale or personal use which usually implies a minimum of two years of ownership.
Until you cash out of real estate, as an investor you can trade properties without incurring a sudden tax obligation. The exchange rules require that both the purchase price and the new loan amount be the same or higher than the original property they are replacing.
types of real estate like-kind exchanges
- 1. Simultaneous exchanges occur when the replacement property and relinquished property close on the same day. These closings occur simultaneously, and a delay can result in the disqualification of the exchange and the immediate application of full taxes.
- 2. Delayed like-kind exchanges are the most common due to the extended timeframe they allow. These occur when a property is relinquished (sold) before a new property is replaced (bought). The exchanger (investor) is responsible for ensuring that all components of the exchange are done correctly and that proceeds from the sale of the relinquished property are held in escrow while the seller acquires a like-kind property. The investor has a maximum of 45 days to identify the replacement property and 180 days to complete the purchase of the replacement property.
- 3. Reverse (or Forward) exchanges occur when a new property is purchased before the relinquished property is sold. Understandably, these exchanges require capital and many banks are not comfortable underwriting such deals.
- 4. Construction/Improvement exchanges allow taxpayers to make improvements on the replacement property by using the exchange equity. The taxpayer can use their tax-deferred dollars to enhance the replacement property while it is placed in the hands of a qualified intermediary for the remainder of the 180-day period.
the seven 1031 starker exchange commandments
- The general rules of the four exchange types are relatively simple and serve as a basic framework.
- 1. To qualify as a 1031 exchange, the property being sold and the property being acquired must be “like-kind.”, real estate, and located in the U.S. Interestingly, Starker exchanges can include the exchange of one property for many or many properties for one.
- 2. A 1031 exchange is only applicable for investment or business property, not personally owned property. In other words, you can’t swap your lake house for a bigger, fancier version.
- 3. The exchange must be of greater or equal value in order to completely defer paying taxes upon the sale of the asset. The IRS requires the net fair market value and equity of the property purchased be the same as, or greater than, the property sold to defer 100% of the tax.
- 4. The transaction must not involve “boot”; although in theory you can complete a partial 1031 exchange with a property of lesser value, however gains will be taxed. This difference is called “boot” and will be the amount for which you have to pay capital gains taxes. It’s still an option, although typically may not be a wise one.
- 5. The same taxpayer name appearing on the title of the property being sold, must be the same as the tax return/title holder that buys the new property. There are exceptions involving modification to LLC members, but this is beyond the scope of this post.
- 6. The property owner has 45 calendar days, post closing of the first property/transfer of title, to identify up to three potential like-kind properties. This can be more difficult than it sounds because replacement properties still need to make sense from a cash perspective and can be complicated due to the seller-overpricing. Note that more than one property can be identified as long as the value of identified properties does not exceed 200% of the value of the property sold.
7. The replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier.
other nuances and important considerations of a 1031 exchange
Along with being a great tax deferment tool, 1031 Starker exchanges also provide solutions to other novel problems. Investors wishing to change the quality and quantity (or even geographical location in the U.S.) of their investments can use Starker exchanges to do just that. High-value or high-maintenance investment properties can be traded for multiple turnkey, high cash flow investment properties for aging investors. Tax deferred status also goes with an investor to the grave. Heirs who inherit property received through a 1031 exchange are “stepped up” to fair market value, the consequence being that deferred taxes are erased. It goes without saying that future taxes may be substantially reduced if the replacement property passes through as an estate and receives a basis step-up to fair market value at date of death.
an experienced appraisal firm is a value added during a complicated exchange
Navigating a 1031 successfully is a team sport. Competent, well-heeled appraisers are real estate economists and important members of your team. Working alongside your tax professionals, appraisers see insights that others may not due to the extensive training they must complete.
After all properties have been identified, you will need an appraisal to determine the fair market value of the real estate involved in the exchange. With the complexities, restrictions and regulations, the appraiser will need to ensure his or her valuations will stand up to IRS scrutiny. In order to qualify for the full tax break, your appraisal will have to prove that you are indeed spending an equal or greater amount of the exchange value.
To be clear, experienced commercial real estate appraisers are not tax professionals. However, Argianas and Associates appraisers are familiar with market trends, forecasts and we routinely are called upon to assist clients in their investment strategies. And importantly, several of our Argianas appraisers have gone through a few Starker exchanges themselves, so we know what it feels like on the other side of the desk or phone.
One final note: 1031 exchanges have not escaped the impact of the pandemic. Sellers that are forced to sell their properties may find limited options, too many options, or discover that their real estate has decreased in value. The expert team at Argianas has experience with the Starker exchange process over the last 30 years and also understands how the realities of today are impacting exchanges in 2020. We would be happy to share that knowledge with you as part of your advising team.