Like most tax topics, the 1031 exchange has a history of changes, primarily due to various legislative and judicial actions. The essential foundation of this tax-deferral strategy is that when investors reinvest the proceeds from selling an asset, they extend the original investment rather than taking their profit and transforming it into spendable cash. As a result, the IRS allowed investors to trade one property for another without paying the applicable capital gains tax.
The Revenue Act of 1921 legitimized both like-kind and non-like-kind exchanges to encourage citizens to invest. However, the subsequent Revenue Act of 1924 removed the eligibility of non-like-kind exchanges. In addition, later legislation further narrowed down the scope of qualified assets presently limited to real property held for business or investment purposes. Nevertheless, exchanges during this time were still limited to real-time swaps between parties.
However, in 1935 the Board of Tax Appeals allowed a taxpayer to complete an exchange using a Qualified Intermediary to receive the proceeds from the relinquished property’s buyer and then convey the funds to the replacement property seller. This decision established the precedent for the modern-day exchange, which is virtually never an actual property swap.
What was the Starker decision?
TJ Starker was a landowner who, in 1979, made a deal with Crown Zellerbach Corporation to exchange timber property for "like-kind" property that was not identified but that Crown promised to convey within five years. The IRS initially rejected the exchange on the grounds that the transaction was not simultaneous. However, the Appeals Court ruled against the IRS, stating that the Federal Tax code did not specify that the exchange must be simultaneous.
Shortly after that, Congress adopted the current 180-day timeline for exchanges and incorporated a 45-day period for the identification of potential replacements. As a result, a “Starker exchange” is the norm in 1031 exchanges, which are rarely simultaneous. In fact, meeting the existing 180-day and 45-day requirements are among the stricter provisions of exchange rules. The difficulty in quickly identifying and acquiring real property has contributed to the prevalence of exchanges using Delaware Statutory Trusts (DSTs) and Real Estate Investment Trusts (REITs) as replacement properties.
Does an exchange eliminate the capital gains taxes?
Completing a 1031 exchange allows an investor to defer the recognition of applicable capital gains, not waive the tax. If the taxpayer later sells the replacement property without using the 1031 exchange again, they would owe the current and previously deferred taxes. In addition, they potentially would be subject to depreciation recapture as well. To maintain the deferral, the investor must continue disposing of property using the 1031 exchange, thus perpetuating the reinvestment of proceeds.
However, inheritance laws allow the owner of a capital asset to bequeath it to an heir who will receive a step-up in basis upon inheritance. That means the heir receives the asset at its current market value and can sell it without paying a capital gains levy. If the inherited property results from one or a chain of 1031 exchanges, the original investor will effectively have eliminated the imposition of capital gains taxes.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.
REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.
There are risks associated with these types of investments and include but are not limited to the following:
- Typically, no secondary market exists for the security listed above.
- Potential difficulty discerning between routine interest payments and principal repayment.
- Redemption price of a REIT may be worth more or less than the original price paid.
- Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.
- There is no guarantee you will receive any income.
- Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.
This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
