If there’s a way to save some money in a real estate transaction, it’s definitely worth exploring – especially if you’re a business property owner or real estate investor. One of the most popular ways to save money in real estate is through a Starker Exchange.
What is a Starker Exchange?
A Starker Exchange, or 1031, happens when an investment owner essentially exchanges one property for another. In doing this, they can avoid paying capital gains taxes during the current transaction. Instead, all capital gains taxes are paid when or if the second property is sold.
The point of a Starker Exchange is to help investors scale their businesses and freeing up funds to buy more valuable properties. But these exchanges can be confusing and aren’t always the best option in every situation.
Reasons to Use a Starker Exchange
There are three main reasons why you should consider a 301 exchange when looking to buy an additional investment or commercial property.
- Defer capital gains. These taxes can add up quickly, especially when you’re selling a valuable property or if you are buying and selling often.
- Avoid depreciation recapture. If you’re selling a rental property, you’ve probably benefited from recording the depreciation in the value of your property for your income tax.
When you go to sell this property, the IRS could recapture some of these funds you’ve written off in the form of capital gains taxes. To avoid this, some landlords will use a Starker Exchange when buying and selling similar properties.
- Leverage your equity. Exchanging a property you own for a more expensive one that will increase your cash flow will allow you to “level up” your investment.
Rules of a Starker Exchange
As we mentioned above, Starker Exchanges can be complicated. If your property meets one or more of the criteria below, it is eligible for an exchange.
- The 3-property rule: The owner identifies three properties that could replace the one they are selling. Only one property must be used.
- The 200% rule: The owner can identify as many properties as they want to replace the one they are selling but their total value cannot be more than 200% of the value of the original property.
- The 95% rule: The most difficult rule to use, this one involves identifying numerous properties of any value. To qualify for the exchange, they must close on 95% of the total value.
A Starker Exchange also requires the use of a qualified intermediary. Usually an attorney, investment banker, or professional QI service, this non-related party will hold onto the money from the original sale until the purchase of the new sale. The only catch here is that they cannot have represented the investor in any capacity within two years of the transfer.
Costs of a Starker Exchange
Just like any real estate transaction, there are closing costs associated with a Starker Exchange.
These could be things like title insurance premiums, property taxes, or attorney’s fees. Some fees can be paid with the funds accumulated through the exchange but others will make you ineligible. Be sure to check with your agent or attorney during the process of your transaction.
You may also hear some funds referred to as a “boot.” While not a technical term, a boot refers to the funds that occur when the mortgage for the replacement property is less than the mortgage of the original property. The IRS views this reduction in mortgage as a taxable cash benefit. Regardless of the Starker Exchange, that amount would be considered a capital gain and taxed as such.
If you think that you could benefit from a Starker Exchange or just want to explore your options further, reach out to our knowledgeable staff at Double Boldt Real Estate. We are here to help you with any and all of your real estate needs – residential, investment, or commercial.