Q: I have heard of a 1031 exchange being called a Starker exchange. Who is Starker, and what did he have to do with this whole process?

A: Good question. Direct exchanges have been provided for in the IRS code for many years. Unfortunately, the likelihood of finding someone who wants what you have and has what you want is quite low. As a result, there are very few direct exchanges. But things began to change in 1967.

In that year, Mr. T. J. Starker and some of his family owned 1,843 acres of timberland in Columbia County, Oregon. The Crown Zellerbach Corporation wanted to buy the land and begin logging operations, but the Starker family had not yet located suitable replacement property. The Starkers were ready to sell, but wanted to defer their capital gain tax on the sale of the land. To solve the dilemma, Crown Zellerbach promised to acquire the replacement properties as Starker found them, then deed them over to Starker.

Under the contract, the Starkers never controlled the credit of one and a half million dollars, which was to be used to acquire the replacement properties. Over the next four years, the Starkers received some twenty parcels, two of which were assigned contracts for purchase. Importantly, Starker received no cash.

After Starker filed his 1967 tax return, the IRS disallowed the exchanges because the transactions were not simultaneous in nature. Starker paid the additional taxes claimed by the IRS, then sued for a refund.

In a confusing series of three cases, the Ninth Circuit held that Starker’s contract with Zellerbach to purchase replacement property was equivalent to an ownership interest. Perhaps more importantly, the court found no requirement in Section 1031 that an exchange must be simultaneous in nature to be legal.

Thus was born the delayed exchange, in which you can sell a property today, then acquire a replacement property in the future and still qualify for deferred gain treatment. Seasoned investors know that the "Starker" delayed exchange is one of the most powerful tax avoidance tools at the real estate investor’s disposal.

Q: Last week, you used the term "safe harbor." What does that mean?

A: In 1994, the Treasury Department issued regulations for exchanges under section 1031. If these rules are followed, then the IRS will allow the exchange to qualify.

Q: What does the term "like-kind" mean?

A: Sometimes called a "like kind" exchange, the IRS requires that the replacement property in an exchange be of the same "nature or quality" as the property disposed of. Fortunately, the IRS treats the term broadly. Thus, any property held for investment is considered "like-kind" to any other property which you intend to hold for investment. Excluded would be your personal or secondary residence, and foreign property.

So raw land can be exchanged for an apartment building, and a rental house can be exchanged for a warehouse.

Q: I understand that I have 45 days to identify up to three replacement properties, but I’m confused on how to structure the exchange so that there will be no tax due.

A: In a nutshell, once you have sold the relinquished property, you have to spend the cash and replace the debt. Any left over cash is treated as capital gain, and you are taxed on it. Likewise, any net debt relief is considered income, and is also taxed as a capital gain.

It is certainly not a disaster to end up with a small tax bill and a good replacement property. But in order to be totally tax-deferred, you will need to buy a replacement property at least as expensive as the one you sold, and spend all the cash received at closing. And don’t forget, the entire process must be completed in a total of 180 days. The day of closing is counted as day zero.

Q: So, what’s the big advantage to exchanging rather than selling? It looks like you are really no better off after the exchange than before it.

A: It all depends on your perspective. By changing the kind of investment property you own, you can completely change your experience.

For example, if you own ten modest rental houses that you manage and repair yourself, you might eventually find the burden of ownership more than you wish to bear. So you might exchange those ten rental houses for 500 acres of timberland in middle Georgia. Now you have no more monthly income, but you might really enjoy hunting or camping on your land, and you can simply wait

for the trees to mature and sell the harvest when the time is right.

By keeping all of your investment dollars at work, you are able to afford more property and better quality property along the course of your investing years.