When T.J. Starker took on the IRS in the late 1970’s, he re-defined how investors could manage their portfolios and permanently changed the core strategies of commercial real estate investors.
The resulting tax code modifications, commonly referred to as the 1031 Starker Exchange, allow commercial real estate investors to defer capital gains tax from the sale of a real estate investment if they apply those profits into the purchase of another real estate investment within a specific time period.
This tax free exchange is not available to those who trade in stocks and bonds and is one of several reasons why 90% of the Forbes 400 use commercial real estate to protect and grow their wealth.
As is the case with most tax law, there are some non-negotiable steps an investor must follow. This article is by no means a substitute for professional tax advice. However, this overview of the key requirements will illustrate the unique real estate investing benefits of the 1031 Starker Exchange.
Let’s review some key rules:
The Investment Must be of Like Kind
An investor must use the proceeds from a sale to invest in another investment of the same kind. This does not restrict selling a shopping center and purchasing an apartment building, but it would prevent selling a shopping center and buying a vacation home. While it is imperative you talk to a tax professional when conducting a Starker Exchange, a good rule of thumb is most U.S. income-producing commercial real estate investments are considered like kind and are eligible for a Starker Exchange.
Using a Qualified Intermediary
In order to comply with IRS regulations, the transaction must be conducted as an exchange rather than a sale and purchase. While this distinction might not seem important, the use of a Qualified Intermediary is a requirement to ensure the transaction meets IRS approval. If you are considering a 1031 exchange, selecting a Qualified Intermediary should occur well in advance of the sale.
A Strict Time Table
While the IRS gives the real estate investor some flexibility in finding a like kind property, there are strict deadlines that must be followed in order to avoid paying capital gains tax. First, you must identify the new property within 45 days of the sale of the original property. Second, you must purchase the property within the 180 days of the sale of the original property. There are a few extensions for these deadlines, which we will cover in Part II (coming in the next few weeks.)
A Quick Example
Restrictions aside, the Starker exchange is considered a vital tool for any commercial real estate investor. A quick comparison between selling stock and selling a commercial real estate property shows you why:
Let’s say you sell several hundred shares of a stock and declare a profit of $100,000. Even if you wish to put that money right back into another investment, you are still required to pay capital gains tax. If the stock was held for over a year, the tax is 15% ($15,000). If the stock was held for less than a year, you are taxed at your current income tax rate which could be as high as 38% ($38,000).
On the other hand, if you sold a commercial multifamily building that also netted a profit of $100,000, you could employ a Starker Exchange and put that profit in a like kind investment within the required timeframe. You would defer $15,000-$38,000 in taxes.
That’s $15,000 to $38,000 of investable proceeds that you can use to control larger assets and generate more income today.
Multiply this advantage over just a few transactions and you will have made a significant jump in your net worth and your current income.