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The New Face of Tax-Deferred Real Estate Investing

NEW YORK (TheStreet) -- As most real estate investors are painfully aware, the Great Recession was a financial collapse second only to the Great Depression.

It brought the end of Lehman Brothers and Bear Sterns, and the near collapse of Citigroup (C) and AIG (AIG).

During this bleak period not so long ago, the financial markets were in utter turmoil. Liquidity markets were frozen and lenders of all sizes hoarded their cash reserves like Silas Marner.

When the dust settled, investors had lost billions of dollars, and the situation for real estate investors was particularly bleak. Property values of all types plummeted cumulatively about 38% from September 2007 through early 2010, according to numbers reported by CoStar Group Inc.

Real Estate Investment Trusts, which depend on both tenant income and the underlying land values, were hit hard during this period, forcing many to make the unpopular choice of suspending or slashing dividends.

Consequently, real estate company valuations fell significantly, and investors watched their fortunes amassed over decades shrink precipitously.

Thankfully, the clouds are parting, and the nation is collectively getting its confidence back. With 2013 newly upon us, many experts point to a building economic momentum, with a slow but steady recovery in residential and commercial real estate, and a growing base of investors planning to increase investments this year.

1031 Exchanges: A Brief History

Prior to the real estate bottom falling out, many real estate investors built their fortunes one property at a time using tax-deferred real estate exchanges, popularly known as "1031s" or"1031 exchanges," after Section 1031 of the Internal Revenue Code. Somtimes they're called "Starker exchanges" after the Starker family, whose victory against the IRS in 1970 allowed for the broader use of 1031 exchanges in real estate.

From the establishment of 1031 exchanges in The Revenue Act of 1918 until the Starker family victory in 1970, the deferral of capital gains taxes was permitted under Section 1031 only for property swaps between two parties.

When the Starker family sold its timberland in the Pacific Northwest to Weyerhaeuser (WY), it put the exchange proceeds from that sale into a trust that was to be used to purchase a replacement property from another entity.

The IRS fought in tax court to disallow the tax deferral in this three-party transaction, but the court ruled in favor of the Starker family. With this verdict, the court created a powerful wealth-building tool for real estate investors. No longer limited to transactions between two parties, investors could defer capital gains taxes on real estate sales as long as the proceeds were used toward the purchase of like-kind or "replacement" properties.

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