Section 1031 of the Internal Revenue Code was created to allow an investor to sell a property, to reinvest the proceeds into a new property and to thereby defer the capital gains into the future. This process is typically referred to as a 1031 tax deferred exchange and when properly structured is a great tool for facilitating portfolio growth and increasing return on investment.
IRC Section 1031 reads “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
As with any IRS code section there are rules that need to be followed carefully to make sure the transaction will qualify. For starters, the properties exchanged must be held for productive use in a trade or business, or for investment. Stocks and bonds are expressly excluded by Section 1031. In addition, the Section does not apply to primary residences, your home. Properties to be exchanged must be “like kind” which means of the same nature and character, even though they may differ in quality and age. Real properties (real estate) generally are considered like kind but they must be classified as real estate within the United States. Overall, the definition of like kind is very liberal allowing for the swapping of raw land with apartments and even includes businesses.
Originally, 1031 exchanges had to take place simultaneously. Now, through what is referred to as a Starker exchange (a legal case) the exchange can be deferred and take place through a qualified intermediary. Under the current rules, a taxpayer must identify the property to be exchanged before the closing and then identify the replacement property within 45 days of the closing. You can designate up to three alternatives as long as one of them is eventually purchased. You have a total of 180 days from the initial closing to complete the exchange. The 45 days for identification runs concurrent with the 180 days to complete the exchange.
There are no limits on how often or how many times you can do a tax deferred exchange but there are some areas to watch out for. Special rules apply when depreciable property is exchanged, especially improved property exchanged for unimproved land can trigger depreciation recapture that will be taxed as ordinary income. Any cash you may receive is known as “boot” and will be taxed as ordinary income. In addition, if you do not receive cash but your mortgage liability goes down, that is considered boot as well, and taxed.
The 1031 exchange is frequently used in commercial real estate and has significant benefits for the long term investor. Simply understanding the rules and working with the right experts makes this a valuable tool not to be passed up.