Monday, February 1, 2010

Realization Events and Starker Deferred Exchanges

What is a Realization Event?

In tax law we collect taxes, such as Capital Gains tax, when there is a Realization Event. To some extent, this is an artificial construct, not a description of a natural occurrence.

Usually, a Realization Event occurs when you sell something or somehow get cash out of a deal. Just because you make money on paper, does not mean you have a taxable Realization Event.

For example, you buy $100 worth of stock in ACME corp. The price of the stock doubles, and ACME is now worth $200. Is this a Realization event? No, of course not. You have not "made" any profit (capital gain) from your ACME stock until you actually sell it. Market prices fluctuate, and by the time you sell the stock, it may in fact have dropped in value.

Moreover, trying to tax these phantom, paper gains, would be a bookkeeping nightmare. Even if it were done only on an annual basis, you would have to keep track of your annual gains and pay taxes (or take losses as write-offs) for years.

In addition, it seems unfair to tax someone on a gain that they have made only on paper. After all, if they did not "cash out" of the deal, where are they going to get the money to pay the taxes?

So it makes sense only to declare a Realization Event when you SELL your Acme stock, and then calculate the taxes based on the gain at the time of sale.

There are some situations, however, where the law allows you to SWAP things, so that you don't have to pay Capital Gains tax - at least for the time being. The so-called Starker deferred exchange, allows you to swap properties without having a Realization Event occur, and also move your Basis from one property to another.

Suppose, for example, you decide to move across country for a job. You own a small rental property in your home town and don't want to manage it remotely. So you decide to buy a new rental property in your new town so you will have some rental income there as well.

Problem is, if you sell the old rental property, that would be a Realization Event, and you would have to pay Capital Gains tax on the sale. If you have been Depreciating the property for many years, your Capital Gains tax could be 15% or more of the entire property value (including State taxes as well!).

Thus, when you go to buy your new rental property in the new town, you'll have 15% less money to invest in it. You won't be able to start over on an even footing.

Now, bear in mind, if you decided to, you could pay the Capital Gains tax from the sale of the property. There is nothing stopping you from doing that. But there are alternatives.

The Starker Deferred Exchange allows you to take the money from one property and then apply it to a new one, without paying any Capital Gains taxes. There are limits and restrictions as to how this works. You have to identify a new property within 45 days of the sale of the old one, for example. Consult your tax consultant or Real Estate agent for more details.

Now some might cry foul and say this is another example of how the tax system favors the very rich. And you might be right to some extent. If you own property, the tax code can be your friend, and reduce your taxes considerably.

But the Starker Deferred Exchange is not a total giveaway. For starters, while you may avoid paying the Capital Gains tax at this particular time, eventually when you sell the new property, you will have to pay taxes on that - provided you don't do a deferred exchange again.

And if you do sell the property, your basis in it will be transferred from the earlier property, minus any Depreciation you continue to make on the new property. So you are not getting a stepped-up Basis or getting a free ride on the backside of all those depreciation deductions you've taken over the years.

Of course, you could keep doing this - flipping one property into another, and not pay the taxes. Then you could leave it to your kids in your will. They would get a "stepped up" basis and not pay any taxes at all on the property.

But, if the property is of any reasonable value, chances are, they'd run up against the Gift and Estate tax (or your Estate will), so completely avoiding taxes might not still be in the picture.

As you can see, the tax code really favors property owners. One reason I got into Real Estate was that it was a good way to legitimately reduce your tax bills. Legitimate tax avoidance is not a crime, but a patriotic duty.

Today, the party in Real Estate might seem to be over. But as prices plummet, some properties will come on the market in the next few years that will seem to be real bargains - and they will be. If you do the math on the overhead, costs, rental income, and the like, you might find a real bargain out there that could be a good nest egg for the future.