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.