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Timing is critical in a tax-free exchange

Dear Steve,
We just completed a "1031 Starker Exchange," selling our single-family home rental property and using the proceeds to acquire a duplex in another part of the country, which we will now put onto the rental market. However, we wish to live in that duplex in about one year's time.

I am getting conflicting information about how long the replacement property in a Starker Exchange must be used as an investment before it can be used as a principal residence. Is it six months? 18 months? Two subsequent tax returns showing rental income? Or none of the above? Advice appreciated. -- Need-to-Know Nancy

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Dear Nancy,
The people at Starker Services surely appreciate the inclusion of their trade name in your question, which I'll be answering presently, or almost presently.

First, for those unfamiliar with a 1031 Exchange, otherwise known as Tax-Free Exchange, Like-Kind Exchange, Delayed Exchange, or yes, a Starker Exchange, it's a handy and oft-used way for sellers of investment properties to defer the payment of capital gains tax on their transactions. When you sell investment real estate, such as the aforementioned single-family-home rental property, you can use the proceeds to buy another income property -- in this case, Nancy's new duplex -- without paying a dime of capital gains taxes. To do so, you must close on the purchase of the second property within 180 days. (A capital gain, by the way, is the difference between the cost and selling price of a property or business, less certain deductible expenses. The term exists mostly for tax purposes).

So in effect, 1031 is a trade-off sanctioned by Congress to promote re-investment. But there are nuances. A qualified intermediary, also known as an accommodator, must hold all money in these deals in trust. You cannot use an employee, your attorney, your broker or your CPA to hold it, nor can you leave it in escrow until the second investment property is purchased. What's more, you've got just 45 days from the date of closing on the "old" property to identify a list of potential "new" re-investment properties, and that period runs simultaneously with the 180-day time limit. Also, you'll want to start structuring the 1031 Exchange at the start of your investment-property sale. And, you must reinvest all the proceeds from it.

Now, back to Nancy's question.

You note that you're getting conflicting advice about how long your replacement property must be used purely as an investment before you can reside there. That could be because there have been attempts by legislators over the years to impose a minimum such as 12 months. But they have failed.

"There is no specific timeframe," says William Huey, senior exchange counselor with Starker Services Inc., an intermediary firm. "Your intent when you buy it qualifies it as an exchange."

However, the better you illustrate that intent by showing your property-management expenses over a given duration on your tax return, the better case you'll make if you ever come into question, Huey says.

In other words, Nancy, it's probably not wise to rent out your place on a month-to-month basis, then boot out the tenant after one or two months. In fact, it's good practice to be frank with your tenant from the start on your eventual intent.

Why the "Starker" moniker, you ask? The exchanges are named for T.J. Starker, who successfully challenged the IRS in the late 1970s over a property exchange he made in partnership with his son and daughter-in-law, Bruce and Elizabeth Starker. The result paved the way for the modern Internal Revenue Code 1031 and today's delayed exchanges. Starker's "delay," starkly speaking, may be the longest one in tax history. It stemmed from a 1967 tax filing!

-- Posted: Dec. 1, 2003




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