Ask members of an older generation about a tax deferred exchange and they will most likely respond with the words “a starker exchange” making no mention of the commonly known term “1031”. Indeed, in the old lexicon “1031” is a meaningless unassigned number. “Starker”, on the other hand, represents a discernable moment in time, more specifically a court case (T.J. Starker v. U.S., 602 F. 2d 1341 9th Cir. 1979), when the tax deferred exchange was given relevancy.
Before “Starker” the 1031 exchange was a cumbersome, expensive, and almost impossible venture. Originally created in 1921, the belief was that the exchange of properties must take place simultaneously, making exchanges inordinately difficult. It required that parties directly swap their properties, such as in a deed swap. The problem was it was almost impossible to find two people who wanted to exchange their properties. Sometimes, deals involving 4 or 5 parties would be attempted, but such endeavors would be routinely fraught with complications and fall apart.
Enter T.J. Starker, a former professor at the University of Michigan, he was wise enough to begin buying “second-growth” forest parcels in 1936 and eventually acquired substantial holdings. A “second-growth” forest is land which was originally de-forested and then replanted, thus having to grow a second time. The genius in buying these parcels was at the time they were severely undervalued. It may seem like common knowledge today, but in Starker’s day forests were seen to be a somewhat inexhaustible resource. There simply was not a large market for second-growth forests because people believed there were a multitude of old-growth forests to choose from. Of course the reality of the situation soon dawned on people and logging companies became eager to pay high prices for land, which a few years prior, they had not considered worth the cost.
Thus we are brought to the Starker case. In 1967 two timber companies, Crown Zellerbach and Longview Fibre, offered to purchase 1,843 acres of land owned by T.J. Starker, his son Bruce and daughter-in-law Elizabeth. The parties encountered a problem when both companies expressed a need to start logging immediately, before the Starker’s had chosen their replacement property. The Starker’s would only concede to hand over their property if it was part of a tax deferred exchange, so the parties struck a deal which would lay the groundwork for the 1031 as we know it today. The Starker’s transferred their land to the respective companies and in exchange credit accounts were set up at each company to be called upon when the Starker’s had settled on a replacement property. Control of cash would never be given to the Starkers, when they settled upon a property it would be purchased by the companies and subsequently transferred. That year the Starker’s tax returns were filed with the transactions treated as being tax exempt.
Enter the IRS, who very quickly disallowed the exchanges because the properties were not exchanged simultaneously. They claimed there could not be a time differential between the transfer of properties and demanded the Starkers pay their taxes. The Starkers paid the taxes and subsequently filed suit, resulting in three court cases.
Starker I (1975)
The first case concerned only Bruce and Elizabeth, they simply sued for a refund of the taxes they paid. Surprisingly, the court sided with them and ordered the IRS to issue the refund. However, no mention was made of the mechanics of the property exchange.
Starker II (1977)
The IRS struck back in the second case, as the court (the same one presiding over Starker I) essentially reversed its decision and claimed that no legal exchange had taken place. The exchange of property for a promise to replace it with suitable property was not deemed to be “like kind” and the deal was declared taxable.
Starker III (1979)
The third time was the charm; in 1979 T.J. Starker filed an appeal with the 9th circuit court contesting the 1977 ruling. The court not only ruled that Starker I barred the government from re-litigating the transfers which were overturned in Starker II but that the requirement for the “simultaneous” exchange in fact did not exist. People were now free to exchange their properties with the delay we currently see as such a common and integral feature today.
So there you have it, the defining moment of the 1031 exchange in a nutshell. Today 1031’s are an invaluable tool people use to continue their investments by deferring the capital gains tax. But the incarnation we have today had to be fought for, had to be won in a battle between one man and the IRS (who desperately did not want it to be easier for people to avoid their taxes). Strange then that we now choose to call such an irreplaceable, tax saving tool by the name the IRS gave it, rather than the name of the man who made it work.Sphere: Related Content
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