Tax Deferred Exchange
Internal Revenue Code Section §1031 allows taxpayers to defer capital gains taxes on the sale of investment or income property. Known as a "1031 exchange" or "Starker exchange", tax deferral is achieved by acquiring like-kind replacement property.
What is the difference between a sale and an exchange?
The sale of real property occurs with the transfer of equity or ownership rights to a buyer, generally for cash or a note. Property sold for cash or a note is actually an exchange of the ownership of the real property for the cash or note. If there is a gain on the sale of a property, the receipt of cash or a note for the property will be a taxable event because cash is not 'like-kind' to real estate. Internal Revenue Code §1031 gives rules and guidelines for the accomplishment of this transfer as a 'non-taxable' sale if the seller receives 'like-kind' real property instead of cash or the note.
Why don't more people know about this?
This method of deferring taxes is not new. The Internal Revenue's favorable tax treatment for investors in real property has been in existence since 1921. Prior to 1979 the 'non-taxable' sale wasn't easy to accomplish because the sale and repurchase of replacement property had to occur simultaneously. That all changed with the famous 1979 Starker court case. The taxpayer, T.J. Starker, challenged the tax court on the need for a simultaneous 'swap' and won. The delayed or Starker exchange became accepted only on the West Coast where the Starker decision occurred. Federal regulations supporting the "Starker" or
delayed exchange format were not finalized and released to the public until April 25, 1991.
When should I consider an Exchange?
The reason investors exchange property is simple: they want to legally defer paying tax on the gain incurred by the sale of property. In an exchange, ownership is simply transferred from one real property asset to another like-kind real property asset. This then is treated under the tax code as a continuation of the ownership of the property rather than a taxable disposition.
The tax-deferred exchange of assets is not a "tax loophole". Nor is it an unspoken privilege open only to wealthy investors. It is a method of equity preservation available to all taxpayers. The benefits extend beyond conserving capital assets. Just as the IRA account protects investor's savings from unnecessary taxation until the savings are converted to income, the I.R.C. §1031 exchange shelters a property investor's increases in the equity, leading to greater profits and economic growth and potentially increased retirement income.