August 23, 1996

TAX BREAKS FOR RENTAL PROPERTY INVESTORS

By TOM KELLY
The Real Estate Advisor

Does Murphy's Law creep more often into the lives of the Irish -- or does it just seem that way?

I definitely have had more than my share of Murphy's Law situations with my old outboard motor boat this summer, but they don't come close to a property deal recently tried by my friend, Mr. Kennedy.

Most homeowners and potential home buyers understand that they can defer the tax on the sale of their principal residence forever as long as they purchase a home of greater value than the one they sold within two years.

For example, if you buy a home for $135,000 and sell it five years later for $178,000, you can defer the tax on the profit ($43,000) as long as you purchase another home costing more than $178,000 within two years. This is called the "residence replacement rule" and includes new construction and extensive remodels, as long as the acquisition and fix-up costs surpass the sale price of your old home.

What is not 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 the game. 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.

My friend, Mr. Kennedy, is not a big time wheeler-dealer. He owned one rental home and certainly did not want to pay a capital gain on the sale of that property now. He 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 within 45 days of the sale of the first property. The problem for Mr. Kennedy was the third key -- closing on the property within 180 days of the sale of the first property.

All three of the properties Mr. Kennedy 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.

And, because he had not all the rules for the tax-free exchange, Mr. Kennedy was going to be hit with a significant capital-gains tax. And, a big question remained: If the exchange was started in 1995 when the first property sold but the facilitator was instructed to hold the funds for 180 days -- which pushed the deal into 1996 -- in what year would the capital gains tax be due?

According to Ed Holleman, accountant in the Seattle accounting firm of William T. Cavender, the deal would be handled as an installment sale. Mr. Kennedy would receive payment at the end of the end of the 180 days, so taxes would be due on the sale in 1996 -- the year he actually took possession of the funds.

This is another reminder to be sure you have a solid place to land before you jump into a tax-free exchange. 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.

Previous columns:

• YURTS -- A CAMPING AND VACATION PROPERTY ALTERNATIVE, 08-16-1996
• FHA LOAN DESIGNED FOR FIX-IT-UPPERS, 08-09-1996
• FOR 99% OF US DREAM HOMES ARE JUST THAT, 07-26-1996
• MORE HUD HELP FOR LOW INCOME BUYERS, 07-19-1996
• WHEN SHOULD YOU TAKE THAT CAPITAL GAINS EXCLUSION?, 07-12-1996
• DEVICE LETS A HOUSE SPEAK FOR ITSELF, 07-04-1996
• THE LAZY DAYS OF SUMMER REAL ESTATE, 06-28-1996
• THERE'S STILL TIME TO APPEAL YOUR PROPERTY TAXES, 06-21-1996