Congress, by passing
the American Jobs
Creation Act of
2004, has plugged an
interesting loophole
in our tax laws. It
has put restrictions
on investors who
obtained property by
way of a like-kind
(Starker) exchange,
and limited their
right to convert the
property into a
principal residence.
This is extremely
complex, and needs
some background
information.
When a real
estate investor
sells property, and
the property has
been held for at
least one year, the
investor will have
to pay capital gains
tax. Currently, the
federal tax rate is
15 percent of the
profit that has been
made.
However, if the
investor wants to
purchase some other
property, there is a
way to defer paying
this capital gains
tax. It is called a
Section 1031
exchange --
otherwise known as a
"Starker Exchange."
Under section
1031 of the Internal
Revenue Code, no
gain is recognized
-- and thus no tax
is paid -- if the
investor exchanges
one piece of real
estate for another,
and complies with
the rules spelled
out by the IRS.
Let's look at how
this works. Investor
owns property A.
This is called the
"relinquished
property." The
property was
purchased for
$100,000, and is now
worth $600,000. For
this discussion, we
will ignore any
depreciation which
the taxpayer has
taken over the
years, but it must
be noted that
depreciation is a
very important
factor in
determining gain.
When the property is
sold, the investor
has made a profit of
$500,000. Under the
current capital
gains tax rate, the
investor will have
to pay $75,000 in
taxes ($500,000 x 15
percent).
However, if the
investor decides to
do a Starker
exchange, this tax
will be deferred.
The investor must
identify a
replacement property
within 45 days from
the date the
relinquished
property is sold,
and must actually go
to settlement on the
replacement property
within 180 days from
the previous sale.
The investor
cannot have any
access -- or control
-- over the
relinquished
property sales
proceeds. They must
be held in escrow by
a neutral third
party, and turned
over directly to the
title attorney
handing the
settlement on the
replacement
property.
If a successful
1031 exchange takes
place, the tax basis
of the relinquished
property becomes the
tax basis of the
replacement
property. Thus, in
our example, even if
the investor pays
$800,000 for the new
property, its basis
will still be
$100,000.
A Starker
exchange is also
referred to as a
"like-kind"
exchange, because
real property must
be exchanged for
other real property.
You cannot exchange
a single-family
house for a piece of
expensive farm
machinery.
However, the
definition of real
estate is very
broad. So long as
the replacement
property is real
estate, the 1031
exchange will work.
Thus, a
single-family house
can be exchanged for
a farm; an office
building for a
vacant lot.
Now, let's look
at what Congress has
just done.
Investor owns a
single-family rental
house in the city.
It has appreciated
considerably. The
investor plans to
retire in two years
to a warm, sunny
place down in
Florida. He sells
the relinquished
house and exchanges
it for a replacement
property in Tampa,
Florida. He rents
out the Florida
house for two years,
and upon retirement,
moves into that
property and treats
it as his principal
residence.
Under other
provisions of the
tax law --
specifically section
121(d) -- if you
sell your principal
residence, and have
lived in it for two
out of the five
years before it is
sold, you can
exclude up to
$500,000 of gain (if
you are married and
file a joint tax
return) or $250,000
if you file an
individual tax
return.
Before the
American Jobs
Creation Act, the
investor could live
in the house for two
years, sell it and
treat it as his
principal residence
-- thereby taking
advantage of the
above-mentioned
exclusions. In other
words, there would
be situations
(depending on the
numbers) where the
investor would be
able to avoid having
to pay any capital
gains tax at all --
or at least paying a
much smaller amount
than would have been
assessed.
However, section
641 of the American
Jobs Creation Act of
2004 has imposed a
five-year
restriction on this
loophole. The new
law specifically
states:
If a taxpayer
acquired
property in an
exchange in
which section
1031 applied,
(section 121(d))
shall not apply
to the sale or
exchange of such
property if it
occurs during
the 5-year
period beginning
with the date of
the acquisition
of such
property.
What exactly does
this mean? In our
example, if the
investor did not
like his Tampa,
Florida house and
wanted to sell it
within five years
from the date of its
acquisition, he
would not be able to
claim the
$250,000/$500,000
exclusion of gain.
He would have to pay
the entire capital
gains tax.
This is not a
major catastrophe
for investors who
want to convert
their replacement
investment property
into a principal
residence. It merely
puts a five-year
waiting period into
the equation. It
should be noted that
the investor can
still defer (or even
avoid) paying
capital gains tax by
going the 1031
exchange route.
Investor sells
the relinquished
property. Within the
statutorily required
180 days, he obtains
the replacement
property. He must
only rent it out for
at least one year in
order to assure that
the process will be
considered a valid
1031 exchange. At
the end of this one
year period, he has
the right to move
into the property,
and convert it to
his principal
residence.
What is not clear
from the new law is
how long after the
five-year period the
investor has to hold
on to the
replacement property
before he can take
advantage of the
Section 121(d)
exclusions. Can he
sell it in year six,
or does he have to
use and own the
property for two
years after the new
statutory five-year
period? I suspect
that the Internal
Revenue Service will
address this issue
at some time in the
future.
A Starker
exchange still makes
sense for the many
investors who have
seen fantastic
appreciation in
their real estate
holdings. And if you
ultimately want to
convert the
replacement property
into your principal
residence, that
option still is
available. Now,
under the new law,
to take advantage of
the exclusions, you
will have to wait at
least five years
before you can sell
it.
Published:
November 8, 2004
Copyright © 2004
Realty Times®.
All Rights Reserved.