Also known as a like-kind exchange, 1031 exchanges get their name from section 1031 of the United States Internal Revenue Code. Section 1031 of the Internal Revenue Code (IRC or the Code) is a significant tax planning tool. It provides an exception to the rule that gain must be recognized on the sale or exchange of real property when certain qualifying property (relinquished property) is exchanged for other qualifying property (replacement property) that is like in kind. Section 1031 of the Code says no gain or loss shall be recognized if real property for use in trade or business or for investment is exchanged for like-kind property.
This gain is not taxed until the new investment property is sold and gain is actually realized. To defer all taxes, taxpayers must both:
- Identify and purchase replacement property equal to or greater in value to the relinquished property.
- Invest into the replacement property all of the net proceeds from the sale of the relinquished property.
Benefits to a 1031 Exchange
Section 1031 exchanges offer many benefits, including one or more of the following:
- Portfolio Management. A property owner can consolidate or diversify its real estate investments as needed.
- Expansive Investing. A property owner can use the savings generated in the exchange to get larger loans to purchase more expensive replacement properties.
- Cash Flow. Sometimes, a property owner can trade a non-income producing property, such as vacant land, for income producing property, such as rental property.
- Strategic Relocation for Growth. A property owner can relocate its investment from an area that may be suffering from a local market downturn to a more healthy market poised to continue steady increases in value.
- Depreciation. The property owner can exchange non-depreciable property for depreciable property according to its tax planning needs.
General Requirements for a Section 1031 Exchange
Under Section 1031, any type of real property interest (other than those specifically excluded) can be exchanged. That is, however, only if the relinquished property and the replacement property are held as real property. Guidelines include:
- Like-Kind Property: broadly defined in the Code and it does not require property of the same or similar use.
- Seller’s Intent. The seller of the relinquished property intends to hold the replacement property for either productive use in a trade or business or investment purposes.
- Strict Compliance with Timeframes. The seller of the discarded property complies with the deadlines for identifying the replacement property and closing the transaction.
- Satisfactory Holding Period. While there is no set time period that a seller of the relinquished property must own it, the IRS factors in the holding period to determine if the owner intended to hold the property for either trade or business or investment.
- Same Person. The person receiving the replacement property is the same as the person who exchanged the relinquished property.
1031 Like-Kind Exchange Timeline
This was just a brief and basic overview of 1031 exchanges. There are many other rules and concepts regarding this topic, so be sure to give us a call to learn more.