If your home is your principal residence, you have a limited number of tax benefits which you can use when filing your 2000 income tax return. Perhaps the most important is the right to exclude up to $500,000 of profit when you sell your home.

Real estate investors, on the other hand, still have to pay capital gains tax when they sell their investment property. Since most investors take annual depreciation when filing their tax returns, the profit -- and thus the capital gains tax -- can often be quite high.

There is a way of deferring payment of this tax, and it's known as a Like-Kind Exchange under Section 1031 of the Internal Revenue Code.

It should be noted that the exchange process is not a "tax free" device, although it is often mistakenly referred to as a "tax-free exchange." It is also called a "Starker exchange" or a "deferred exchange." Although a like-kind exchange will not necessarily relieve you from the ultimate obligation to pay the capital gains tax, it will, however, allow you to defer paying that tax until you sell your last investment property.

A recent Tax Court case explains the underlying concept of the exchange. "The primary reason that has been given for deferring recognition of gain under section 1031(a) on exchanges of like-kind property is that the exchange does not materially alter the taxpayer's economic position; the property received in the exchange is considered a continuation of the old property still unliquidated." (Decleene v Commissioner, 2000 US Tax Court, November 17, 2000).

The rules are complex, and the Internal Revenue Service and the Tax Court have made it clear that the legal requirements for a successful exchange must be followed carefully and strictly. Here is a general overview of the process.

Section 1031 permits a non-recognition of gain only if the following conditions are met:

• The property transferred (called by the IRS the "relinquished property") and the exchange property ("replacement property") must be "property held for productive use in trade, in business or for investment." Neither property in this exchange can be your principal residence, unless you have abandoned it as your personal house.

• There must be an exchange; the IRS wants to ensure that a transaction that is called an exchange is not really a sale and a subsequent purchase.

• The replacement property must be of "like kind." The courts have given a very broad definition to this concept. As a general rule, all real estate is considered "like kind" with all other real estate. Thus, a farm can be traded for an office building, a condominium or cooperative unit for raw land, or a single family home for commercial or industrial property.

Once you meet these tests, and before you embark on the exchange route, it is important that you analyze your tax situation. If you do a like-kind exchange, your profit will be deferred until you sell the replacement property.

However, you should understand that the cost basis of your new property in most cases will be the basis of the old property. Discuss this with your accountant to determine whether the savings gained by using the like-kind exchange will make up for the lower cost basis on your new property. Also discuss with your tax advisor whether it makes sense to obtain new investment property: i.e., should you remain a landlord; or are you better off paying the capital gains tax and pocketing the balance of your sales proceeds.

The traditional, classic exchange (A and B swap properties) rarely works. Not everyone is able to find replacement property before they sell their own property. In a case involving a man named Mr. Starker, the Supreme Court held that the exchange does not have to be simultaneous, and hence the concept of a "Starker exchange."

Congress did not like this open-ended interpretation, and in 1984, two major limitations were imposed on the Starker (non-simultaneous) exchange.

First, the replacement property must be identified before the 45th day after the day on which the original (relinquished) property is transferred.

Second, the replacement property must be purchased no later than 180 days after the taxpayer transfers his original property, or the due date (with any extension) of the taxpayer's return of the tax imposed for the year in which the transfer is made.

These are very important time limitations, which should be noted on your calendar when you first enter into a 1031 exchange.

In 1989, Congress added two additional technical restrictions.

First, property located in the United States cannot be exchanged for property outside the United States.

Second, if property received in a like-kind exchange between related persons is disposed of within two years after the date of the last transfer, the original exchange will not qualify for non- recognition of gain.

In May of 1991, the Internal Revenue Service adopted final regulations which clarified many of the issues. And on September 15, 2000, the IRS finally got around to issuing rules dealing with "reverse exchanges;" i.e., situations where the replacement property is obtained before the relinquished property is sold.

This column cannot analyze all of these regulations. The following, however, will highlight some of the major requirements which are applicable for regular exchanges.

1. Identification of the replacement property within 45 days.

According to the IRS, the taxpayer may identify more than one property as replacement property. However, the maximum number of replacement properties that the taxpayer may identify is either three properties of any fair market value, or any number of properties as long as their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of all of the relinquished properties.

Furthermore, the replacement property or properties must be unambiguously described in a written document. According to the IRS, real property must be described by a legal description, street address or distinguishable name (e.g., The Excalibur Apartment Building)."

2. Who is the neutral party?

Conceptually, the relinquished property is sold, and the sales proceeds are held in escrow by a neutral party, until the replacement property is obtained. Typically, an intermediary or escrow agent is involved in the transaction. In order to make absolutely sure that the taxpayer does not have control or access to these funds during this interim period, the IRS requires that this agent cannot be the taxpayer or a related party.

The holder of the escrow account can be an attorney or a broker engaged primarily to facilitate the exchange, but an attorney who has represented the taxpayer on other matters during the previous two years is ineligible to be the neutral party.

3. Interest on the exchange proceeds.

One of the underlying concepts of a successful 1031 exchange is the mandatory requirement that not one penny of the sales proceeds be available to the seller of the relinquished property under any circumstances unless the transactions do not take place.

Generally, the sales proceeds are placed in escrow with a neutral third party. Since these proceeds may not be used for the purchase of the replacement property for up to 180 days, the amount of interest earned can be significant.

The Internal Revenue Service allows the taxpayer to earn interest -- referred to as "growth factor" -- on these escrowed funds. Any such interest to the taxpayer has to be reported as earned income. Once the replacement property is obtained by the exchanger, the interest can either be used for the purchase of that property, or paid directly to the exchanger.

The rules are complex, and you must seek both legal and tax accounting advice before you enter into any like-kind exchange transaction. If you fail to strictly comply with the rules, you may have to pay the capital gains tax on the profit you thought you deferred, plus interest and penalties.

For more articles by Benny Kass, please press here.

Published: February 19, 2001

Use of this article without permission is a violation of federal copyright laws.

Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of Kass, Mitek & Kass, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts. Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.