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.