What is a Section 1031 Exchange or Starker Exchange? What is a Section 1031 Exchange or Starker Exchange?
A 1031 Exchange, also known as a Starker Exchange, provides real estate investors the ability to defer capital gains tax on investment property transactions by selling an investment property and using the proceeds from the sale for the purchase of a like-kind replacement property. Starker refers to the Taxpayer who successfully challenged the IRS to allow what are known today as deferred exchanges.
Key Takeaways:
- A 1031 Exchange, also known as a Starker Exchange, involves the sale of an investment property in exchange for a like-kind replacement property (or properties) to defer capital gains tax.
- Whereas all “real property” may qualify, the term like-kind refers to how the real estate asset must be used or held for investment purposes.
- Property that is NOT an investment property and disqualified from being involved in a 1031 Exchange includes a primary residence, a second home, property being flipped or not held for investment purposes, or property held in inventory for sale.
- The transaction must be structured as an exchange with a Qualified Intermediary, and not just a normal sale.
As you can imagine, a 1031 Exchange process can be complicated, which makes working with a Qualified Intermediary like Leader1031 all the more important. Below, we'll dive into what a 1031 exchange is, how they work, how to get started with an exchange, and more!
What is a 1031 Exchange?
As mentioned above, a 1031 Exchange involves the sale of an investment property in exchange for a like-kind replacement property (or properties) to defer capital gains tax. In general, any real property can be exchanged provided it is held for “investment” or for the “productive use in a trade or business”. To complete an exchange, the relinquished property must be exchanged for property of “like-kind” that will also be held for one of those investment purposes. This is often referred to as the “held for” rule.
To qualify, there are a number of steps the taxpayer must take to ensure it qualifies under the 1031 guidelines. First, the transaction must be structured as an exchange and not just a sale. Second, a Qualified Intermediary must be involved prior to the closing of the relinquished property to create an exchange agreement with the taxpayer and obtain other documentation. Third, the taxpayer must timely identify any replacement property or properties in writing. Finally, the QI must hold the proceeds during the exchange period and apply them only toward the acquisition of replacement property.
What is Like-Kind Property in a Section 1031 Exchange?
To be eligible for a 1031 exchange, the exchange of property must involve real property held for business use or investment purposes. These exchanges cannot be used for primary or second homes.
What exactly can be considered like-kind property in a 1031 exchange? How similar does the property actually have to be to the property being sold to qualify? Whereas all “real property” may qualify, the term like-kind refers to how the real estate asset must be used or held for business use or investment purposes. For example, industrial property can be exchanged for a single-family rental property, or retail property can be exchanged for a multi-family residential rental property.
What is Disqualified as Like-Kind Property in an exchange?
Simply put, disqualified property is property that is NOT an investment property including, but not limited to; a primary residence, a second home, properties being flipped, or a property held in inventory for sale. In addition, recent changes to tax law disallow personal property (artwork, boats, etc.) as valid property in a 1031 exchange at the federal level.
1031 Exchange Rules
As a result of the Starker decision, the IRS created guidelines for delayed exchanges. The taxpayer has 45 days from the closing date of the relinquished property to identify replacement property. Proper identification is a requirement for a valid exchange, and the investor can only acquire property which has been properly identified during the 45-day identification period. Replacement property that is acquired (i.e. closes) within the 45-day ID period is considered properly identified. For property not acquired within the first 45-days, the identification must unambiguously describe the property (with an address or legal description), and must be made in writing, signed by the taxpayer, and sent before midnight of the 45th day to the QI. If multiple relinquished properties are grouped together in one exchange, the 45-day period starts to run as of the closing of the first relinquished property. The identification form is incorporated into our Exchange Agreement.
There are several identification rules:
- Three-Property Identification Rule: The investor may identify up to three replacement properties regardless of their fair market value. This does not mean that the taxpayer must close on all three properties. It's simply an opportunity to purchase one or more of those three properties through the exchange.
- The 200% Rule: The investor may identify any number of properties so long as the total fair market value of all the identified properties does not exceed 200% of the value of the relinquished property. Note: exceeding 200% of the value causes the third rule to apply.
- 95% Rule: If more than three replacement properties are identified and the sum of all identified properties exceeds 200% of the value of the relinquished property, then the taxpayer must acquire at least 95% of the total fair market value of all identified properties, otherwise, the entire exchange will fail.
How to Get Started with a Starker Exchange
The first step investors should take when exploring the benefits of a 1031 exchange is to ensure they have surrounded themselves with the appropriate team of professionals to guide them through the process including a tax advisor, attorney, real estate agent, and Qualified Intermediary.
Finding the right Qualified Intermediary to work with is crucial to the 1031 exchange process because it helps verify the security of your funds and provides your entire team with knowledge and experience that they might not otherwise have.
Your qualified intermediary will interact with your realtor, tax advisor, escrow professional, attorney, and representatives for the property you are purchasing, so it's extremely important to make sure you choose a QI who can guide your team through the complexities of the process while meeting all of the important associated deadlines.
Leader Bank's 1031 exchange subsidiary, Leader1031*, serves as a qualified intermediary for real estate investors seeking to sell and purchase property using the tax-deferred advantages of a 1031 exchange. These services provide greater integration and efficiencies for our commercial real estate clients, and Leader1031 is committed to providing the highest quality of service.
As soon as your relinquished property has gone into contract, you can set up a 1031 Exchange account with Leader1031. This 1031 Exchange account and certain documentation provided by your QI must be in place prior to the close of your relinquished property sale.
Leader1031 is ready to help ensure your transactions are in full compliance with IRS Code Section 1031. Contact Leader1031 today!.
The content of this publication is provided as general information only and should not be taken as legal, investment or other professional advice. This content of this publication shall not be construed as a recommendation to participate in any particular trading, financial or investment strategy, and neither Leader Bank, NA nor Leader1031.com, LLC can provide legal or tax advice concerning the specific tax consequences of a given transaction. Any action that you take as a result of information or opinions provided in this publication is ultimately your responsibility. Consult your attorney, accountant, or tax professional before making any investment or financial decisions.To ensure compliance with requirements under Treasury Department Circular 230, we inform you that the contents of this publication are not intended or written to be used, and may not be used, for the purpose of (i) avoiding U.S. federal tax penalties or (ii) promoting, marketing, or recommending to another party any matter addressed herein. Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax adviser.
