The rules are complex, and the time limitations are strict, but if you plan to sell investment property, the Starker (like-kind) exchange will allow you to defer the profit you make.

Let's take this example. In the 1970's, you and your new spouse bought your first house for $30,000. You raised three children and in the early 1980's, that house was just too small for your growing family.

You bought a larger house, but decided to keep the old residence and rent it out. It is now worth approximately $700,000.

If you sell, you will have to pay capital gains tax on the profit. For this discussion, we will ignore any improvements which you have made, although when you calculate your profit, these improvements will increase your tax basis and thus lower your tax obligations.

You have made a gross profit of $670,000 ($700,000 - 30,000). There are other costs and expenses which will reduce your profit, such as real estate commissions, legal fees, and closing costs, but for our example, these items will not be considered. The current federal tax rate is 15 percent, and thus you will owe the IRS $100,500. You may also have to pay State tax on this profit. There is a way of deferring payment of this tax, and it is known as a Like-Kind Exchange under Section 1031 of the Internal Revenue Code.

This is not a "tax-free" exchange, although that is what it is often called. It is also called a "Starker exchange" or a "deferred exchange." It will not relieve you from the ultimate obligation to pay the capital gains tax. It will, however, allow you to defer paying that tax until you sell your last investment property.

The ideal exchange is a direct exchange. I own investment property A and you own property B (also investment). Both are of equal value. On February 1, 2006, you convey B to me and on that same day I convey property A to you. If there is a written agreement between us that this is to be a 1031 exchange, neither of us will have to immediately pay any capital gains tax on any profit we have made.

However, such a transaction is rarely possible. The logistics of finding the replacement property to be exchanged simultaneously with the relinquished property is very difficult, if not impossible to coordinate.

Many years ago, a man by the name of T.J. Starker sold property in Oregon, pursuant to a "land exchange agreement," but did not receive any money for the sale. Instead, the seller -- a couple of years later -- transferred replacement property to Mr. Starker. The Internal Revenue Service considered this a taxable sale, but the 9th Circuit Court of Appeals held that this was a deferred exchange which was permitted under Section 1031 of the Tax Code. In other words, the exchange did not have to take place simultaneously.

There are two kinds of deferred (Starker) exchanges:.

• a forward exchange: you sell the relinquished property, and within the time limitations spelled out in Section 1031, you obtain the replacement property; and

• a reverse exchange: you obtain title to the replacement first, and then sell the relinquished property.

The rules are complex, but here is a general overview of the process. With some important exceptions (discussed below) the rules apply equally whether the exchange is forward or reverse:

Section 1031 permits a delay (non-recognition) of gain only if the following conditions are met:

First, the property transferred (called by the IRS the "relinquished property") and the exchange property ("replacement property") must be "property held for productive use in trade, in business or for investment." Neither property in this exchange can be your principal residence, unless you have abandoned it as your personal house. Your vacation home would also not qualify as investment property, unless you actually start to rent it out more or less full time.

Second, there must be an exchange. The IRS wants to ensure that a transaction that is called an exchange is not really a sale and a subsequent purchase.

Third, the replacement property must be of "like kind." The courts have given a very broad definition to this concept. As a general rule, all real estate is considered "like kind" with all other real estate.

Thus, a single family house can be exchanged for a condominium (or cooperative) unit; raw land can be swapped for an office building, and a farm can be exchanged for commercial or industrial property.

Before you decide to do an exchange, it is important that you determine the tax consequences. If you do a like-kind exchange, your profit will be deferred until you sell the replacement property. However, it must be noted that the cost basis of the new property in most cases will be the basis of the old property. Discuss this with your accountant to determine whether the savings by using the like-kind exchange will make up for the lower cost basis on your new property. Additionally, if your capital gains tax will be relatively small, you may decide just to pay the tax and not be a landlord anymore.

Here is a general overview of the requirements:

1. Identification of the replacement property within 45 days. Congress did not like the fact that the Starker opinion imposed no time limitations on when the exchange could take place. Accordingly, the law was amended to require that the taxpayer identify the replacement property no later than 45 days after the relinquished property has been sold.

   A taxpayer may identify more than one property as replacement property. However, the maximum number of replacement properties that the taxpayer may identify is either three properties of any fair market value, or any number of properties as long as their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of all of the relinquished properties.

   Furthermore, the replacement property or properties must be unambiguously described in a written document. According to the IRS, real property must be described by a legal description, street address or distinguishable name (e.g., The Excalibur Apartment Building).

2. Who is the neutral party? Perhaps the most important requirement of a successful 1031 exchange is that the taxpayer cannot receive (or control) even one penny of the net sales proceeds from the relinquished property. All such proceeds must be held in escrow by a neutral party, and go directly into the purchase of the replacement property. Generally, an intermediary or escrow agent is involved in the transaction.

   In order to make absolutely sure that the taxpayer does not have control or access to these funds during this interim period, the IRS requires that this agent cannot be the taxpayer or a related party. The holder of the escrow account can be an attorney or a broker engaged primarily to facilitate the exchange.

3. Take title within 180 days: The replacement property must be obtained no later than 180 days after the relinquished property is transferred or the due date of the taxpayer's income tax return for the year in which the transfer is made. If, for example, you transferred the relinquished property on December 15, 2005, your tax return is due on April 15, 2006. That is only 121 days. You either have to take title to the replacement property by that date or get an extension from the IRS so that you can extend out to the full 180 days. It should be noted that as of this year, instead of the four month automatic extension, you can now opt for a six month automatic extension by filing IRS form 4868.

4. Interest on the exchange proceeds. The interest which is earned while the sales proceeds are held in escrow is called the "growth factor," and any such interest to the taxpayer has to be reported as earned income. Once the replacement property is obtained by the exchanger, the interest can either be used for the purchase of that property, or paid directly to the exchanger.

   Reverse exchanges: As many taxpayers have discovered, it is sometimes difficult to meet the 45/180 day requirements. You have found the replacement property, but do not yet have a buyer for the relinquished property. And the owner of the new property is not willing to wait until you are able to go to closing on your current property.

Thus, you may have to go the reverse Starker route. Here, in very general form, are some of the important rules:

1. The taxpayer must arrange for the replacement property to be held in a "qualified exchange accommodation arrangement." In government language, this will now be called "QEAA."

2. Qualified indicia of ownership of the property by the QEAA is required. This means that the QEAA must either have legal title to the replacement property or other some other arrangement which is acceptable to the IRS to demonstrate ownership. A land sales contract (also called "contract for deed") may suffice.

   Under this latter arrangement, the QEAA will not have actual legal title, but will have certain obligations under a contract. This may -- depending on state or local law -- avoid having to pay a double recordation-transfer tax. Otherwise, this tax must be paid when the property is first transferred to the QEAA and then again when it is transferred to the ultimate taxpayer.

3. No later than five business days after the property is transferred to the QEAA, the taxpayer and the exchange accommodation titleholder (called the QEAT) must enter into a written agreement which provides that the latter is holding the property for the benefit of the taxpayer in order to facilitate an exchange under section 1031. Generally, this can be accomplished by a lease of the property from the QEAT to the taxpayer.

4. Both the taxpayer and the exchange accommodation titleholder (the QEAA) must file separate federal income tax returns, so as to advise the IRS of any income and expense incurred while the QEAT had ownership of the property.

5. No later than 45 days after the replacement property is transferred, the taxpayer must identify the relinquished property. The IRS allows the taxpayer to identify alternative and multiple properties, and if the taxpayer owns several investment properties, this provides some flexibility as to which property will be sold.

6. No later than 180 days after the replacement property is transferred to the QEAT, it must be conveyed to the taxpayer.

7. Perhaps the most important aspect of a reverse Starker is the requirement that the taxpayer have a bona fide intent to engage in a 1031 exchange. According to the IRS regulations:

At the time the qualified indicia of ownership of the property is transferred to the exchange accommodation titleholder, it is the taxpayer's bona fide intent that the property held by the property ... in an exchange that is intended to qualify for non-recognition of gain (in whole or in part) or loss under §1031.

In other words, you cannot buy the replacement property and then -- as an afterthought -- decide to treat the transaction as a 1031 exchange.

The rules are extremely complex. You must seek both legal and tax accounting advice before you enter into any like-kind exchange transaction -- whether forward or reverse.

Published: February 6, 2006

Use of this article without permission is a violation of federal copyright laws.

Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of Kass, Mitek & Kass, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts. Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.