This was copied from the Association of Realtors
NEW BEDFORD, Mass. – April 6, 2016 – Question: Years ago, we moved to a larger home but decided to rent it out. It has been a successful investment. We are nearing retirement, and want to move to Florida in a few years. If we sell the investment property, we will have to pay a lot of capital gains tax. Someone told us we should do a Starker exchange, obtain a house in Florida and then move into it. Is this doable? – Matt
Answer: Yes, Matt, if you follow the rules, that can work. What’s a Starker exchange? It is named after Mr. Starker, who sold a property but did not have access to the sales proceeds; they were held in escrow by a neutral party. Later, he bought another property and the escrow funds went right into that purchase.
Starker claimed he did not have to pay capital gains tax on the sale because he did a Section 1031 “Like Kind Exchange,” which is authorized by the tax code. The court agreed and that gave birth to the real development of this transaction.
Congress was not satisfied with the open-ended transaction in Starker so it amended the law. Now, you have to identify the replacement property (or properties) within 45 days from the date the old property (called “relinquished property) is sold and buy the replacement property within 180 days from the date of the earlier sale. If your income tax comes due (April 15) during the 180 days, you either have to get the automatic extension or take title to the replacement property by that date.
Let’s say you sold your relinquished property on January 30, 2015, and were able to locate and take title to the replacement property on April 1, 2016. Both properties must be held for investment, but the question is “for how long?”
Nancy Grekin is an attorney in Hawaii and has written what I consider the definitive book on 1031 Exchanges. She writes: “When clients want to move into improved 1031 property I recommend they wait at least two years – the longer the better but after two years it is said by revenue agents to be ‘old and cold.'”
I have heard some tax attorneys say it’s OK if you wait one year and one day, but I would be on the safe side and wait at least two years.
Why should you consider a 1031 exchange? Contrary to popular belief, it is not a “tax free” transaction. But it does defer the tax you would have to pay. Oversimplified, the capital gains tax you save when you do such a Starker exchange will be paid if and when you sell the replacement property.
As always, I cannot provide legal advice, so please consult with your own tax and legal advisors.
First, the property transferred (the “relinquished property”) and the exchange property (“replacement property”) must be “property held for productive use in trade, in business or for investment.” Neither properties in this exchange can be your principal residence, unless you have abandoned the property as your personal house.
Second, there must be an exchange; the IRS wants to ensure that this is not really a sale and a subsequent purchase.
Third, the replacement property must be of “like kind.” As a general rule, all real estate is considered “like kind” with all other real estate. Thus, a farm can be exchanged for a condominium unit, a single-family home for an office building, or raw land for commercial or industrial property.