November 7, 2024
Gaithersburg, MD--Today, many real estate investors are considering “tax-deferred exchanges” as a method of delaying capital gains taxes on the sale of their investment property. Many investors have seen the value of their real estate increase dramatically and they are looking for a way to sell their investment property, without immediately paying taxes. The investors are often concerned that they will have to pay a large amount of capital gains taxes, and thus the investors are looking for a solution to defer that tax payment.
The good news is that under Section 1031 of the Internal Revenue Code, no gain or loss is recognized on the exchange of property held for investment if such property is exchanged solely for property of a like-kind which is to be held for investment. While that sounds easy, it is critical that the investor understands that Section 1031 and IRS rulings mandate certain minimal requirements to be satisfied for a successful exchange.
First, to give an example, let’s take an investor who wants to sell a long-held townhouse. It is required that the townhouse must be held for business or investment purposes. This is likely to be a rental property for the investor, so that part of the requirement is easily satisfied. If our investor wants to “trade up” to a single-family house, the property to be received in the exchange, (the single family house in our case), must be of a “like-kind.” This means the properties must be similar in nature, although not necessarily in quality. For example, an unimproved lot may be exchanged for a rental building, or a single-family house can be exchanged for a warehouse, because they are all real estate, albeit of a different quality.
In theory, the perfect exchange would occur when our investor who owns the townhouse simply exchanges title to the townhouse with the person who owns the single-family house. This would be a fair trade or exchange. But the likelihood of actually finding two people who want each other’s properties is virtually zero, and thus, other methods of completing an exchange have evolved.
Although there are an infinite number of combinations of transactions which may ultimately qualify as a tax-free exchange, the most common exchange is a “Starker” exchange, named after the taxpayer who was involved in a dispute with the Internal Revenue Service over the timing of the sale and purchase of the investment properties. This delayed, non-simultaneous exchange is often referred to as a “Starker” exchange following a series of court cases wherein the Federal Courts recognized and ultimately sanctioned the use of a non-simultaneous or delayed exchange
Although the series of transactions may seem confusing at first glance, in actuality, they are not too complicated. Generally, the Starker exchange consists of the sale of the initial investment property, (the townhouse in our case) the placing of the sales proceeds in an independent account held by a third party facilitator known as a qualified intermediary, and the subsequent identification and purchase of the new replacement property, which would be the single family house in our hypothetical transaction.
The rules require that the taxpayer must identify the new property to be purchased within forty-five (45) days from the date of closing on the original townhouse investment property. The identification process involves giving notice to the qualified intermediary, which is usually a completely separate company that specializes in serving in that role. The identification notice must be in writing and must specify the address or legal description of the new replacement property. Generally, the taxpayer can identify up to three potential replacement properties, but the taxpayer does not have to buy all three of the properties. This gives the taxpayer investor the opportunity to study which property he or she wants to ultimately purchase.
The next step is that our investor who sold the town house must close on the new investment property within one hundred eighty (180) days after the sale of the original townhouse investment property. Generally speaking, the investor must use all of the cash from the sale of the townhouse for the purchase of the replacement single-family house. Also, the taxpayer investor cannot have any net mortgage relief. In other words, the new replacement property will likely cost the same or more than the sales price of the town house because the taxpayer will use up all of the cash from the sale of the townhouse, will likely have the same or even a larger mortgage on the new property, and the end result is that the new single-family house costs the same or more than the townhouse. If the investor tries to take some of the cash out of the transaction, this may be a taxable event.
There are many steps involved in completing the exchange through a qualified intermediary, including the inclusion in the Listing Agreement of certain provisions, a special addendum to the contract of sale on the sale of the investment townhouse, possibly a special addendum in the replacement property contract which the Buyer’s agent will need to know about, closing on the sale of the townhouse, and identifying and then settling on the new replacement property. The inability to properly satisfy one of the technical requirements of Section 1031 may result in a determination that the entire exchange is invalid. In that instance, our investor would lose all of the beneficial tax treatment afforded under Section 1031 of the Internal Revenue Code.
Thus, in completing an exchange, it is of the utmost importance that the investor seeks the advice of an experienced attorney, accountant and/or a qualified intermediary. The attorneys at Kriss Law/Atlantic Closing and Escrow, as well as the attorneys at Village Settlements, an Atlantic Closing and Escrow Company can help the investor with the settlements on both the original investment property as well as the replacement property, regardless of what State the properties are located in. We can also help to arrange for the qualified intermediary to serve their role in the transaction. Readers are encouraged to speak to any of attorneys if they have questions.
David Parker is an attorney and the Managing Director of Village Settlements-an Atlantic Closing and Escrow Company. His columns have appeared regularly in local newspapers, magazines, and newsletters. He is the co-author of the book, “Real Estate Practice in DC, Maryland and Virginia.” If you have a topic that you would like him to write about, he can be reached at dparker@villagesettlements.com
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