Tax-Free Exchanges: Helping sellers avoid a big pitfall

Most people know that home sellers, regardless of age, may pocket $250,000 tax free if single and $500,000 if a married couple when they sell their homes as long as they’ve had the home for two full years as their principal residence.

What is not always common knowledge is that you can do the same thing with investment property, and you don’t have to be a big-time wheeler-dealer to play. In fact, most tax-free exchange specialists say their typical customer is a 50-year old with two or three rentals or a retired couple who merely want to keep the family home as an investment – not exactly the connotation of “rich” as defined by American business.

This trading process is called a 1031 Delayed Exchange, or Starker Exchange. It is named after T.J. Starker, an Oregon man who made a deal with Crown Zellerbach in 1967 to exchange some of his forested property for some “suitable” future property. That agreement ended up in court. Starker’s battle was the basis for congressional approval of delayed exchanges.

And, the Starker move is not really a true exchange at all. It is the process of rolling the funds from one property into another without having access to those funds. In doing so, capital gains tax can be deferred. However, make sure you are standing on two confident “property” legs – selling and buying – before you make a move.

Consider this sad tale:

A Seattle man was attempting to complete a 1031 exchange. He had met two of the three most important keys to the exchange – identify properties of equal or greater value and within a 45-day window of the sale of the first property. The problem became the third key – closing on the property within 180 days of the sale of the first property.

All three of the properties the man had identified had been sold to higher bidders. The cash from the sale of his original home was tied up for 180 days because he had started the exchange process by hiring a facilitator to handle the exchange. He ended up paying a huge capital gain because he missed the

180-day deadline.

Identifying the replacement properties within the 45-day time limit seems to be the difficult leg, but the most challenging part often is getting the transaction to the closing table. And, you can’t make a 1031 exchange stand up on just one leg.

One more word of caution: Even though federal capital gains tax is avoided in the swap, most states will charge sales tax, sometimes known as “excise tax” on both properties even though no cash was exchanged. That’s because “consideration” was given in both deals. Consideration does not have to be cash – it can be another property.

Remind your seller to plan on paying at least some tax – even in a rental home.