Deconstructing real estate exchanges

Tax-deferred deals get 'downright easy'
By: Robert J. Bruss: Inman News
As longtime subscribers know, my first tax-deferred exchange was the trade of a three-unit building at 1264 Third Ave. (just down the steep hill from UCSF Hospital) for a nine-unit apartment building at 4605 Balboa St. (overlooking the famous Playland at the Beach) in San Francisco. Having read in William Nickerson's great book about the benefits of tax-deferred exchanges for pyramiding real estate wealth, I was anxious to make my first tax-deferred trade.

I shall always be grateful to Walt Lembi, and his dad Frank Lembi (now in his 80s and still selling real estate!), at Skyline Realty in San Francisco for showing me how "real world" tax-deferred simultaneous exchanges were done before 1984 (when "delayed" Starker exchanges became available).

The first step was to find a cash buyer for my three units. Walt and Frank took care of that within a few weeks. The second step was to find a property for the trade up.

Finding a qualifying replacement property to complete the trade is usually the hardest part of a tax-deferred exchange. Clyde Cournale Realty in San Francisco had a listing on a suitable nine-unit "fixer upper" building. The motivated seller accepted my exchange purchase offer, contingent on the simultaneous trade and "cash out" sale to the waiting buyer already arranged by Skyline Realty.

All went very well. I got my simultaneous tax-deferred trade up, the seller of the nine units got his taxable cash, and the buyer of my three units got a good starter investment property. Everybody was happy, even Uncle Sam who received his capital gain tax on the sale of the nine-unit building.

TODAY'S "STARKER EXCHANGES" ARE MUCH EASIER. Although simultaneous exchanges still occur, if this same tax-deferred exchange occurred today it would be much easier. The reason is Internal Revenue Code 1031(a)(3), the so-called Starker exchange rules. Starker exchanges have now become the "standard" type of realty exchange. Even large corporations use Starker exchanges to avoid capital gain tax on profitable real estate sales and property replacements.

For those not familiar with the late T.J. Starker and his very important contribution to tax-deferred exchange, I'll give you the short version of his story. He owned some Oregon timberland that Crown-Zellerbach Corp. wanted to acquire at a huge capital gain profit to Starker.

He deeded his land to C-Z, which credited Starker with the sales price, plus a 6 percent "growth factor" until he could find suitable qualifying "like kind" property to acquire with that money for completion of the exchange. After Starker acquired other property he liked with the funds C-Z was holding for him, the IRS said he owed tax on his profit because it wasn't a direct simultaneous exchange (as I did with my three units for the nine units).

Starker paid the disputed tax (to stop the running of interest) and then sued the IRS in U.S. District Court for a tax refund. He won! But the IRS appealed to the Ninth Circuit U.S. Court of Appeals. The IRS lost!

The happy result for realty investors is we now have IRC 1031(a)(3), which was enacted by Congress in 1984, establishing the Starker exchange rules. You can read the fascinating case at Starker v. U.S., 602 Fed.2d 1341.Thanks to T.J. Starker, today's tax-deferred "delayed" exchanges are downright easy.

The first step is to find a buyer for the investment or business property you want to sell. When a buyer makes a suitable purchase offer, be sure the sales proceeds will be held by a qualified third-party intermediary beyond your constructive receipt. If you receive the sales cash, or have the right to do so, that ruins your tax-deferred exchange. Leaving the sales proceeds in escrow means you have a right to receive the cash so the sale is disqualified as a Starker tax-deferred exchange.

The second step, when the sale of your old investment or business property closes, is to be sure the sales proceeds go directly to a qualified third-party intermediary, such as a bank trust department that specializes in Starker tax-deferred exchanges, or to the exchange subsidiary, which most large title companies now can provide.

There are also independent exchange facilitator companies. If you select one of these independents, be sure your funds are well protected. Some of these small companies have gone bankrupt, causing loss of tax-deferred exchanges for their clients (see In re Sale Guaranty Corp., 220 B.R. 600, for a classic example what can go wrong for exchangers when the third-party intermediary accommodator goes broke).

The third step is to use the cash from your property sale, being held beyond your constructive receipt by the qualified third-party intermediary or accommodator, to purchase the suitable replacement property to complete the tax-deferred exchange.

There are several very important rules for designating this replacement property:

1. The replacement property must be designated in writing to the exchange accommodator intermediary within 45 days after the sale of your old property closes;

2. Not more than three possible properties can be designated (however, you can withdraw one possible property from your list and substitute another property during the 45 days);

3. As an alternative, you can designate more than three properties if their total fair market value does not exceed 200 percent of the fair market value of the relinquished property;

4. IRC Regulation 1.1031(k-1(e)) allows designating within the 45 days a replacement property that includes a contract to construct, build, install, manufacture, develop or improve property to be acquired. However, a property already owned by the exchanger cannot qualify under this regulation.

Within 180 days following the sale of the old property held for investment or business use, the acquisition must be completed. No time extension is allowed by the tax statute or regulations.

To avoid being under extreme time pressure to meet the 45-day and 180-day deadlines, one method is to delay the closing date for the sale of your old investment or business property. A second method is to rent the old property to the prospective buyer on a lease-option to be exercised on a date to be designated by the seller after a suitable replacement property is under purchase contract.