In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.
The concept behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.
What is a 1031 Exchange?
Internal Revenue Code (IRC) Section 1031 is one of the last remaining tax loopholes. It is a powerful tool that allows investors to exchange any investment property for any other investment property. For your exchange to be valid, you must follow specific IRS regulations.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Here is an abbreviated list of the regulations:
The properties being exchanged must be of like kind.
For example, you may exchange:
- A house for another house (or several houses)
- A house for commercial real estate land for rental property
- A strip mall for an office building any investment property for any other investment property (as long as it is not occupied as your primary residence)
- You must identify and close on your replacement property within a specific period of time.
- 100% of the proceeds from your current property must be held by a Qualified Intermediary and applied toward your replacement property to get a full tax deferral.
- Your replacement property must be of equal or greater value to the property you have sold to get a full tax deferral.
- Properties being exchanged must be used for investment. Personal residences are not exchangeable