by Benny L. Kass
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
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Realty
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