Generally, you will pay capital gains tax whenever you sell investment or business property. However, IRC Section 1031 provides an exception that allows you to defer the tax on the gain if you reinvest the proceeds in similar property. The gain deferred in these qualified like-kind exchanges will be rolled over into the new property and will be deferred until that property is sold. This allows investors to save thousands in upfront taxes that can be reinvested and potentially grow tax-free.
What is a Section 1031 Exchange?
Section 1031 refers to the Internal Revenue Code section that allows for tax deferred like-kind exchanges. For a 1031 exchange to happen, there must be an exchange of property. The simplest type of Section 1031 exchange is a direct and immediate trade of one property for another. For example, trading in a vehicles used for business purposes for a new one.
Deferred exchanges, as relating to real estate property, are more complex but offer more flexibility. This allows for the disposition of property with the subsequent purchase of one or more like-kind replacement property shortly thereafter.
However, and this is where it gets complicated, simply selling one property and using the proceeds to purchase another property is not a qualified section 1031 exchange. Rather, to qualify as a deferred exchange, the sale and subsequent acquisition of business or investment property must be “mutually dependent parts of an integrated transaction constituting an exchange of property” per the IRS.
For this reason, taxpayers who wish to engage in deferred exchanges will use a facilitator under an exchange agreement. This ensures the exchange meets the qualifications under rules provided in the income tax regulations.
What Property Qualifies Under a Section 1031 Exchange?
Both the property that is sold and the property that is subsequently purchased must meet certain criteria to qualify as a deferred exchange:
- Both properties must be business use or investment property
- Both properties must be similar enough to qualify as a like-kind exchange
- Both properties must not fall under the category of excluded property under section 1031
Excluded property under section 1031 are as follows:
- Inventory or stock in trade
- Stocks, bonds or notes
- Other securities or debt
- Partnership interest
- Certificates of trust
Typically, most real estate transactions will qualify as a like-kind exchange. However, property primarily used for personal use, such as a primary residence or a vacation home, does not meet the qualifications of a like-kind exchange.
Be leery of any facilitator who purports otherwise. Sales pitches, typically coming from non-tax professionals, may encourage individuals to exchange non-qualifying personal property. Many promoters may even refer to qualified exchanges as “tax-free” instead of correctly describing the transaction as “tax deferred.”
Who Qualifies for Section 1031 Exchange?
C-corporations, S-corporations, Individuals, trusts, partnerships (general or limited), limited liability companies, and any other taxpaying entity may qualify to set up an exchange of business or investment properties under Section 1031.
Consult a Tax and Real Estate Advisor
The effective use of section 1031 exchanges can defer thousands of dollars in taxes by rolling over these gains into new business use or investment property. These transactions are complicated and have restrictions as well as time sensitive deadlines. A non-qualified exchange could result in thousands of dollars in taxes that will be difficult to pay because the proceeds from the sale was reinvested into a new property. For this reason it is important to consult with a trusted tax and real estate adviser.