Tax Deferred Exchanges and Investment Property

By David Parker, Esq.

QUESTION: Several years ago, I purchased an investment townhouse which I have been renting out. The property has substantially increased in value, and I am considering selling the townhouse. However, I am afraid that I will have to pay taxes on my profits. I am also considering purchasing another investment property, only this time, a single family house. Is there any method for selling the townhouse and purchasing the new single family house while deferring the taxes on the profits?

ANSWER: Today, many real estate investors are considering “tax-deferred exchanges” as a method of delaying taxes on the sale of investment property. 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. However, Section 1031 provides certain minimal requirements which must be satisfied for a successful exchange.

First, the initial property to be sold, the townhouse in your case, must be held for business or investment purposes. Next, the property to be received in exchange, the single family house in your 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, as they are both real estate, albeit of a different quality.

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. The 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 your property, the placing of your sales proceeds in an independent account held by a third party facilitator or trustee, and the subsequent identification and purchase of the new replacement property. The rules require that you identify the new property to be purchased within forty-five (45) days from the date of closing on the original investment property. Additionally, you must close on the new investment property within one hundred eighty (180) days after the sale of the original investment property. There are many steps involved in completing the exchange through a trustee, including the inclusion in the Listing Agreement of certain provisions, a special addendum to the contract of sale on the sale of your townhouse, closing on the sale of the townhouse, and identifying and then settling on the new 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, you would lose all of the beneficial tax treatment afforded the investor under Section 1031. In completing an exchange, it is of the utmost importance that you seek the advice of an experienced attorney and/or accountant.