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What Should You Know Before Planning A 1031 Exchange?

by Rishav

It is a common practice for real estate investors to desire to switch out one investment for another to boost cash flow. The IRS permits capital gains taxes to be deferred when one property is exchanged by another on time. Section 1031 of the Internal Revenue Code dictates the tax operation of such transactions. These are referred to as 1031 exchanges or Starker exchanges (after a court verdict known as the Starker ruling). Starker Exchange is also mentioned in Internal Revenue Service (IRS) statutes and in their preamble. 

IRC Section 1031 provides an opportunity for a well-organized exchange letting investors sell a property and reinvest the sale proceeds in a newly built property and defer all capital gain taxes. IRC Section 1031 (a)(1) states:

“No loss or gain will be recognized on exchanging real estate owned for productive use in a business or trade or for investment purposes if such asset is exchanged solely for a like-kind asset which should be owned either for productive use in a trade or business or for investment.”

Origin of the term

The name Starker Exchange originates from a series of 1970s court cases, including Starker family members who took a tax-deferred exchange to an entirely new height. The Starkers’ conveyed timberland in return for a promise that the buyer would give a suitable replacement property within five years. To keep the buyer invested, the agreement introduced a 6 percent annual increase factor. 

After an extended legal battle between the taxpayer and the IRS concerning the validity of a delayed period (five years) to effectuate an exchange, the taxpayer won in Federal District tax court. In response to the Starker case decision, Congress, as part of the Tax Reform Act of 1984, decided to squeeze up the exchange period dramatically. Now investors are limited to 45 days to formally identify a potential replacement property and 180-day period to acquire it as instructed by Section 1031. Congress recognizes that for an exchange for being valid, it does not necessarily need to take place on a simultaneous basis. However, it did place constraints on the open-ended nature of the Starker decision.

Like any modern-day exchange, the taxpayer is not permitted to receive or have any interest in the funds owed by the buyer for the acquisition of taxpayer’s property; however, these funds are needed to purchase the replacement property. To facilitate this, it was decided that any property would be put in trust for the advantage of the parties but out of the ownership of either party. The trust would ensure that the buyer’s funds are utilized to acquire the replacement property, and the amount remaining after 180 days would be repaid directly to the seller/taxpayer. This trust was also referred to as the Starker Trust. Although the Starker Trust went away in 1991, to this day, many people still use the name of a “Starker exchange.”

Understanding Section 1031

Section 1031 defers tax on properly structured 1031 exchanges. For 1031 exchanges concluded before December 31, 2017, like-kind property covered a comprehensive range of tangible and real personal property owned for business or investment such as securities, stock in trade, partnership interests, franchises, art, equipment, certificates of trust, and beneficial interests. Any 1031 Exchange arranged after December 31, 2017, required the permissible property to be a business or investment real estate. 

Fundamentally, people deem that Starker Exchanges or 1031 Exchanges are only suitable for real property. However, they can be used to everything from businesses, cars, artwork, all kinds of things. Investors also need to be cautious to ensure that they comprehend the guidelines laid down by the IRS.

Example of concerned taxpayer 

Matt, the taxpayer, has an investment property that he wishes to exchange in a 1031 tax-deferred exchange for a replacement property currently in possession of Linda. Matt has arranged a purchase agreement with Linda that grants for the closing to occur within 30 days. John has agreed to buy Matt’s relinquished property, but John is unable to arrange funds for at least 90 days. Consequently, Matt is handling a classic reverse Starker exchange if he acquires Linda’s property before transferring his relinquished property to John.

To maximize the desirable tax outcomes of a 1031 exchange, the investor must organize the transaction accurately. For example, if, as part of the trade, you take any cash or a non-qualifying property (e.g., furnishings), the IRS will recognize gains to the full extent of this compensation. IRS specifically dictates that any compensation must be of like-kind to be eligible for 1031 Exchange purposes. If processed correctly, such tax-deferred exchanges are as good as getting an interest-free loan from the government in the amount of the taxes that would otherwise be owed.

1031 Exchange lets you earn maximum profit by reinvesting your sale proceeds into a new asset. 1031 exchanges are quite complex in nature, and the assistance of professionals or 1031 experts is required. 

Our 1031 experts can help you close your investment days before the actual deadline.

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