| back |
by John R. Galley, ESQ.
QWhat is the strategy and use of a tax-deferred exchange?
ABy using the technique described in IRS Code Section 1031, the real estate investor sells his or her existing investment property. Then, using the prescribed rules for accompanying paperwork and handling the sale proceeds, the investor reinvests these proceeds in a new real estate purchase of equal or greater value. This technique will not trigger any capital gains tax. Any tax is postponed.
QIs the Starker exchange a safe technique or is it an aggressive tactic that invites IRS scrutiny and challenge?
AAfter losing several tax cases to the Starker family in the late Ď70s and early Ď80s, the IRS acquiesced to the idea of a delayed exchange by including it in the 1984 Tax Reform Act. The approved mechanics for doing an exchange were further clarified in 1991 regulations. The IRS created safe harbors for doing exchanges. When done properly, a like-kind exchange is a totally approved tax-avoidance technique.
QWhat, exactly, is a Starker exchange?
AThe concept of an exchange has long been a part of the tax code (Section 1031), but had been basically limited to a simultaneous exchange. The exchanger transferred the relinquished property and acquired the replacement property simultaneously. The Starker cases sanctioned an expanded envelope to permit the relinquished property to be transferred immediately and the replacement acquisition event to be delayed until a later date. A delayed exchange has now become the most common type of exchange and is commonly known as a Starker exchange.
QCan you state the rule in simple English?
AIf you sell a property and correctly reinvest the proceeds in a new purchase of equal or greater value, you donít have to pay any tax at this time. Both the property you start with and the one(s) you end up with must be for your business or investment. Both must be the same kind of property. The Starker exchange doesnít apply to inventory or dealer property (like a builder or developer). You have to identify the property or properties you want to acquire by the 45th day after you closed on the property you sold. And you must close on the new property or properties within 180 days of the initial sale.
QUse of the word exchange is potentially confusing. Is there a better descriptive label we can give this technique?
AThe reality of what occurs is an interdependent sale and purchase. Another way to describe this is the investment roll-over rule, since this is a first cousin to the well-known former residential roll-over rule (formerly Section 1034). The truth of the matter is, the label "exchange" is little more than a legal fiction.
QWhat does like-kind mean?
AMany people erroneously construe this term narrowly (i.e. vacant land for vacant land or duplex for duplex). This is wrong. The IRS construes the term like-kind very broadly when the subject is real estate. Literally anything that is real estate (even a 30-year lease!) is acceptable. Itís that simple!
QWhat is this identification business?
AWithin 45 days after the closing on the relinquished property, the exchanger is required to identify what he/she intends to acquire. All that is needed is a simple memorandum that identifies the target properties. It is simply kept in the file (of the intermediary) to be available in the unlikely event of an audit. One of three rules can be used.
QWhat are the key elements necessary to have a completely tax-deferred exchange?
AThree components are necessary.
QCan multiple properties be relinquished and/or acquired in the same exchange?
AMultiple properties can be both relinquished and acquired if all the rules of timing are met.
QWhat role is played by a qualified intermediary?
AThe 1991 regulations established safe harbors (approved procedures) for doing exchanges. A critical safe harbor is the use of a qualified intermediary. The use of this entity permits the fiction of an exchange to be preserved (instead of an outright sale and subsequent purchase). The exchanger enters into an exchange agreement with a qualified intermediary. The steps are that the exchanger transfers it to the buyer. The intermediary holds the transfer proceeds in a special trust until a replacement property is found. The intermediary then acquires the replacement property from the seller and transfers it to the exchanger. The rules permit the intermediary to instruct the parties to deed directly between themselves. When the procedures and paperwork are done correctly, this is a safe harbor exchange. Use of the intermediary eliminates any need to have participation and cooperation of the other parties in the transaction.
QWho can act as a qualified intermediary?
AYou should choose someone who is both trustworthy and knows what he is doing. Beyond that, it may be easier to state whom the regulations forbid. Relatives of the exchanger and business professionals (lawyers, accountants, investment bankers) with whom the exchanger has an ongoing relationship may not serve as the intermediary.
QWhy canít the exchanger hold and control the transfer proceeds until the replacement property is acquired?
AHaving sale proceeds must mean a sale occurred - hence a taxable event. The exchanger must not have any control over the money - actual or constructive - or the exchange will be disallowed. An impenetrable screen must be placed between the exchanger and the money. The intermediary trust accomplishes this. The IRS regulations now permit the exchanger to earn and receive interest on the proceeds while in the trust.
QHow can the exchanger get cash money if necessary? Is technique all or nothing?
AThe technique is not all or nothing. There are two ways to obtain cash money.
QIf the technique is tax-deferred, not tax-free, why not pay the tax and get it over with?
AThere are several good reasons not to pay the tax now, but rather to defer it.
QWho will try to talk the prospective exchanger out of doing an exchange?
AGenerally, it could be anyone who is afraid to admit they donít know about, or understand exchanges. Some argue against exchanging saying the basis in the new property will be lower and therefore, there is less to depreciate. (Basis in the new property is lowered by the unrealized gain from the old property.) This is too simplistic!
QCan a specific property have two classifications?
ASometimes a property can have a dual characteristic - residential and investment. An excellent example is a three-flat where the owners live in one unit and rent the other two. Using both the Primary Residence Rule (formerly 1034) and the investment rollover rule (1031) on different portions of the same property can produce a completely non-taxable event.
QCan you mix an installment sale and an exchange?
ASeller-held financing (mortgage or land contract) on the relinquished property will usually significantly reduce the tax-deferred benefits of an exchange and create substantial tax. The simple rule is: donít do them. But if some seller-held financing is necessary to make the deal work, keep it to a minimum. However, on the replacement purchase, seller-held financing presents no problem.
QCan the classification of a property be changed to accommodate use of the 1031 Rule?
AReal estate owned by any given individual has two basic categories: residential or investment. The character of a piece of real estate can be changed from one to the other, but it takes planning, time, and cannot defy logic or credibility. Remember the unwritten IRS smell test; if it smells bad, it is bad!
QCan 1031 be used for vacation homes?
AVacation homes (a secondary residence) may fall between the cracks of the Primary Residence Rule and 1031. They may qualify for neither because it isnít the primary residence and the owner makes too much personal use of the property. (Other IRS rules appear to indirectly support this.) A vacation home used only two weeks of the year for personal use and rented (or made available for rent) the rest of the year (the Florida or Hawaii condo) can qualify for 1031. However, some taxpayers choose to take an aggressive position on this issue feeling that a second home is a form of investment and use the exchange technique when they sell. Itís a matter of personal choice.
QSometimes we hear that Congress is going to change or narrow the use of exchanges. Will they do this?
ASomeone once aptly observed, "No manís purse is safe when Congress is in session." Of course, there is always the possibility that Congress might change exchange rules and/or mechanics. Suggested changes are sometimes floated in committee, but little or nothing usually comes of them. The reality is that any changes that have occurred have been favorable to the taxpayer. Bottom line, if any changes were made, they could only apply to future exchanges, not exchanges completed or in progress.
QAre there any reasons not to do an exchange?
AThere are only two reasons that make any sense.
QHow important is it to do an exchange?
AThe importance boils down to the difference between having money or not having it - paying significant dollars in taxes that are lost forever, or keeping that money for yourself. Anyone who sells, pays taxes and then buys instead of exchanging should be kicked out of the Real Estate Investorsí Club!
Starker Exchange Requirements Checklist
Who is John Galley?
John R. Galley is a practicing real estate attorney with offices in Antioch, Illinois (Lake County) and Chicago. His offices have represented clients in thousands of residential real estate closings. He is also co-owner of Blackhawk Title Services and acts as a Qualified Intermediary for Starker Exchanges.
John fulfills the mandatory role of Qualified Intermediary in Starker Exchanges. This activity requires scrupulously accurate paperwork and a proper and safe management of the Exchangerís funds.
John is licensed in both Illinois and Wisconsin and is a member of both State Bars. He has acted as qualified intermediary for hundreds of exchanges. He attends special exchange seminars each year and was schooled by the two lawyers who wrote the Starker Exchange regulations for the IRS. John also gives frequent seminars to real estate agents and lawyers nationwide on exchange issues.
Why should John Galley be the designated intermediary for your Starker exchange? Some title companies and bank trust departments offer to fulfill the intermediary role; often the primary person you deal with is not even a lawyer. They have proper paperwork and manage the funds correctly, but if you have any questions about rule interpretations, creative strategies or tactics, their response is likely to be, "Talk to your lawyer." There is no one to explain the process in plain English. John, with his vast knowledge and experience, works closely with all parties on these subjects.
Johnís fees for exchanges are very competitive. Unlike most title companies, there is no additional, incremental charge for the amount of money held in the Starker Trust. Johnís knowledge, helpfulness to all parties in the transaction, and competitive prices make him an excellent Exchange Intermediary value. John can be reached at 847-838-4200.