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Starker Tax-Deferred Exchange

by John R. Galley, ESQ.

Q What is the strategy and use of a tax-deferred exchange?

A By using the technique described in IRS Code Section 1031, the real estate investor sells his or her existing investment property. Then, using the prescribed rules for accompanying paperwork and handling the sale proceeds, the investor reinvests these proceeds in a new real estate purchase of equal or greater value. This technique will not trigger any capital gains tax. Any tax is postponed.

Q Is the Starker exchange a safe technique or is it an aggressive tactic that invites IRS scrutiny and challenge?

A After losing several tax cases to the Starker family in the late Ď70s and early Ď80s, the IRS acquiesced to the idea of a delayed exchange by including it in the 1984 Tax Reform Act. The approved mechanics for doing an exchange were further clarified in 1991 regulations. The IRS created safe harbors for doing exchanges. When done properly, a like-kind exchange is a totally approved tax-avoidance technique.

Q What, exactly, is a Starker exchange?

A The concept of an exchange has long been a part of the tax code (Section 1031), but had been basically limited to a simultaneous exchange. The exchanger transferred the relinquished property and acquired the replacement property simultaneously. The Starker cases sanctioned an expanded envelope to permit the relinquished property to be transferred immediately and the replacement acquisition event to be delayed until a later date. A delayed exchange has now become the most common type of exchange and is commonly known as a Starker exchange.

Q Can you state the rule in simple English?

A If you sell a property and correctly reinvest the proceeds in a new purchase of equal or greater value, you donít have to pay any tax at this time. Both the property you start with and the one(s) you end up with must be for your business or investment. Both must be the same kind of property. The Starker exchange doesnít apply to inventory or dealer property (like a builder or developer). You have to identify the property or properties you want to acquire by the 45th day after you closed on the property you sold. And you must close on the new property or properties within 180 days of the initial sale.

Q Use of the word exchange is potentially confusing. Is there a better descriptive label we can give this technique?

A The reality of what occurs is an interdependent sale and purchase. Another way to describe this is the investment roll-over rule, since this is a first cousin to the well-known former residential roll-over rule (formerly Section 1034). The truth of the matter is, the label "exchange" is little more than a legal fiction.

Q What does like-kind mean?

A Many people erroneously construe this term narrowly (i.e. vacant land for vacant land or duplex for duplex). This is wrong. The IRS construes the term like-kind very broadly when the subject is real estate. Literally anything that is real estate (even a 30-year lease!) is acceptable. Itís that simple!

Q What is this identification business?

A Within 45 days after the closing on the relinquished property, the exchanger is required to identify what he/she intends to acquire. All that is needed is a simple memorandum that identifies the target properties. It is simply kept in the file (of the intermediary) to be available in the unlikely event of an audit. One of three rules can be used.

  1. List three properties, in order of preference, and then choose your property or properties from this list. Their cumulative value may be unlimited.
  2. List as many properties as you wish; pick from the list, but the cumulative value of the properties listed cannot exceed 200% of the value of the relinquished property.
  3. List as many properties as you wish having an unlimited cumulative value, but you must then purchase properties having 95% of the value (which effectively means all of them).

Q What are the key elements necessary to have a completely tax-deferred exchange?

A Three components are necessary.

  1. The acquired property must be equal or greater in value than the relinquished property.
  2. All of the proceeds money from the relinquished property must be used to acquire the new property. If the exchanger keeps any of this money, it is considered boot and tax must be paid on the money that is kept.
  3. The exchanger must not have debt relief. If a mortgage is retired with the transfer of the relinquished property, then a mortgage of equal or greater value must be placed on the acquired property at the time of acquisition. If a new mortgage is for less than the balance due on the mortgage that was retired, this is considered to be debt relief and the exchanger would be taxed on the difference. However, this problem can be overcome if the exchanger puts new cash, equaling or exceeding the debt relief, into the purchase.

Q Can multiple properties be relinquished and/or acquired in the same exchange?

A Multiple properties can be both relinquished and acquired if all the rules of timing are met.

Q What role is played by a qualified intermediary?

A The 1991 regulations established safe harbors (approved procedures) for doing exchanges. A critical safe harbor is the use of a qualified intermediary. The use of this entity permits the fiction of an exchange to be preserved (instead of an outright sale and subsequent purchase). The exchanger enters into an exchange agreement with a qualified intermediary. The steps are that the exchanger transfers it to the buyer. The intermediary holds the transfer proceeds in a special trust until a replacement property is found. The intermediary then acquires the replacement property from the seller and transfers it to the exchanger. The rules permit the intermediary to instruct the parties to deed directly between themselves. When the procedures and paperwork are done correctly, this is a safe harbor exchange. Use of the intermediary eliminates any need to have participation and cooperation of the other parties in the transaction.

Q Who can act as a qualified intermediary?

A You should choose someone who is both trustworthy and knows what he is doing. Beyond that, it may be easier to state whom the regulations forbid. Relatives of the exchanger and business professionals (lawyers, accountants, investment bankers) with whom the exchanger has an ongoing relationship may not serve as the intermediary.

Q Why canít the exchanger hold and control the transfer proceeds until the replacement property is acquired?

A Having sale proceeds must mean a sale occurred - hence a taxable event. The exchanger must not have any control over the money - actual or constructive - or the exchange will be disallowed. An impenetrable screen must be placed between the exchanger and the money. The intermediary trust accomplishes this. The IRS regulations now permit the exchanger to earn and receive interest on the proceeds while in the trust.

Q How can the exchanger get cash money if necessary? Is technique all or nothing?

A The technique is not all or nothing. There are two ways to obtain cash money.

  1. Use all of the trust proceeds to acquire the replacement property except the money that is wanted/needed. Then after the exchange is completed, the exchanger takes the money left in the trust. However, the exchanger will be taxed on the money (boot) that is taken.
  2. Use all of the trust proceeds to acquire the replacement property. Then, after a suitable period of time, borrow against this equity now in the replacement property to get the needed cash. Loan proceeds are not taxable. Tenants will pay back the loan with their rental payments.

Q If the technique is tax-deferred, not tax-free, why not pay the tax and get it over with?

A There are several good reasons not to pay the tax now, but rather to defer it.

  1. Every dollar not paid in tax can be used to purchase more property. (Each dollar saved and used also allows the exchanger to borrow additional money to use for purchasing.) Using and compounding this money means that at some later date, even if the tax is eventually paid, the exchanger will have a lot more money than he would have by selling, paying taxes, then buying.
  2. The exchanger may be in a lower tax bracket at some future point (after retirement) and tax may be less burdensome then.
  3. There is one technique that eliminates the tax: Exchange until you die! The heir(s) receives the property owned by the deceased with a basis that is the fair market value on the date of death. All accumulated untaxed appreciation is eliminated.

Q Who will try to talk the prospective exchanger out of doing an exchange?

A Generally, it could be anyone who is afraid to admit they donít know about, or understand exchanges. Some argue against exchanging saying the basis in the new property will be lower and therefore, there is less to depreciate. (Basis in the new property is lowered by the unrealized gain from the old property.) This is too simplistic!

  1. There is more to successful real estate investing than depreciation. Depreciation isnít that big a deal.
  2. By not paying the tax, the exchanger has more money to work with and can buy a more expensive building than he could have otherwise. (Remember, most real estate investments are typically leveraged 3:1 at the beginning.) The exchanger now has more building to depreciate and it should about equal the depreciation on the less expensive building with the high basis-to-value ratio. And, the exchanger has a bigger, better building!

Q Can a specific property have two classifications?

A Sometimes a property can have a dual characteristic - residential and investment. An excellent example is a three-flat where the owners live in one unit and rent the other two. Using both the Primary Residence Rule (formerly 1034) and the investment rollover rule (1031) on different portions of the same property can produce a completely non-taxable event.

Q Can you mix an installment sale and an exchange?

A Seller-held financing (mortgage or land contract) on the relinquished property will usually significantly reduce the tax-deferred benefits of an exchange and create substantial tax. The simple rule is: donít do them. But if some seller-held financing is necessary to make the deal work, keep it to a minimum. However, on the replacement purchase, seller-held financing presents no problem.

Q Can the classification of a property be changed to accommodate use of the 1031 Rule?

A Real estate owned by any given individual has two basic categories: residential or investment. The character of a piece of real estate can be changed from one to the other, but it takes planning, time, and cannot defy logic or credibility. Remember the unwritten IRS smell test; if it smells bad, it is bad!

Q Can 1031 be used for vacation homes?

A Vacation homes (a secondary residence) may fall between the cracks of the Primary Residence Rule and 1031. They may qualify for neither because it isnít the primary residence and the owner makes too much personal use of the property. (Other IRS rules appear to indirectly support this.) A vacation home used only two weeks of the year for personal use and rented (or made available for rent) the rest of the year (the Florida or Hawaii condo) can qualify for 1031. However, some taxpayers choose to take an aggressive position on this issue feeling that a second home is a form of investment and use the exchange technique when they sell. Itís a matter of personal choice.

Q Sometimes we hear that Congress is going to change or narrow the use of exchanges. Will they do this?

A Someone once aptly observed, "No manís purse is safe when Congress is in session." Of course, there is always the possibility that Congress might change exchange rules and/or mechanics. Suggested changes are sometimes floated in committee, but little or nothing usually comes of them. The reality is that any changes that have occurred have been favorable to the taxpayer. Bottom line, if any changes were made, they could only apply to future exchanges, not exchanges completed or in progress.

Q Are there any reasons not to do an exchange?

A There are only two reasons that make any sense.

  1. The person absolutely doesnít want to own any more real estate - even if the price is paying a considerable tax.
  2. The person is desperate for all the cash proceeds - again, even if the price is paying taxes.

Q How important is it to do an exchange?

A The importance boils down to the difference between having money or not having it - paying significant dollars in taxes that are lost forever, or keeping that money for yourself. Anyone who sells, pays taxes and then buys instead of exchanging should be kicked out of the Real Estate Investorsí Club!

 

Starker Exchange Requirements Checklist

 

Who is John Galley?

John R. Galley is a practicing real estate attorney with offices in Antioch, Illinois (Lake County) and Chicago. His offices have represented clients in thousands of residential real estate closings. He is also co-owner of Blackhawk Title Services and acts as a Qualified Intermediary for Starker Exchanges.

John fulfills the mandatory role of Qualified Intermediary in Starker Exchanges. This activity requires scrupulously accurate paperwork and a proper and safe management of the Exchangerís funds.

John is licensed in both Illinois and Wisconsin and is a member of both State Bars. He has acted as qualified intermediary for hundreds of exchanges. He attends special exchange seminars each year and was schooled by the two lawyers who wrote the Starker Exchange regulations for the IRS. John also gives frequent seminars to real estate agents and lawyers nationwide on exchange issues.

Why should John Galley be the designated intermediary for your Starker exchange? Some title companies and bank trust departments offer to fulfill the intermediary role; often the primary person you deal with is not even a lawyer. They have proper paperwork and manage the funds correctly, but if you have any questions about rule interpretations, creative strategies or tactics, their response is likely to be, "Talk to your lawyer." There is no one to explain the process in plain English. John, with his vast knowledge and experience, works closely with all parties on these subjects.

Johnís fees for exchanges are very competitive. Unlike most title companies, there is no additional, incremental charge for the amount of money held in the Starker Trust. Johnís knowledge, helpfulness to all parties in the transaction, and competitive prices make him an excellent Exchange Intermediary value. John can be reached at 847-838-4200.