Definition
Section 1031
Section 1031 of the Internal Revenue Code permits tax-deferred exchanges of specific types of property. This provision allows taxpayers to defer capital gains taxes on compatible properties used for business, investment, or productive use in trade as long as certain criteria are met.
Key Requirements
The following are the key conditions to qualify for a Section 1031 tax-deferred exchange:
- Exchange or Qualifying as a Delayed Tax-Free Exchange: The properties involved in the transaction must be exchanged either directly or through a delayed exchange process.
- Like-Kind Property: The exchanged properties must be of “like-kind,” meaning they must be of the same nature or character, such as real estate for real estate.
- Held for Trade, Business, or Investment: The properties must be held for use in trade, business, or as an investment.
Examples
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Example 1: Lowell trades her appreciated land for Baker’s shopping center. Both properties have equal equities. Here, Lowell’s adjusted tax basis in the land becomes her adjusted tax basis in the shopping center, enabling her to defer any capital gains taxes.
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Example 2: An investor exchanges an apartment building held for rental purposes for an office building. Both properties qualify under Section 1031, and the investor defers capital gains on the appreciated value of the apartment building.
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Example 3: A farmer swaps farmland for a commercial warehouse. Even though the properties are not the same in utility, they are considered “like-kind” because both are real properties used in trade or business.
Frequently Asked Questions
What types of properties qualify for a Section 1031 exchange?
To qualify, properties must generally be like-kind real estate, held for investment or business purposes. This includes things like apartment buildings, commercial properties, vacant land, and single-family rentals.
What does “like-kind property” mean?
“Like-kind” refers to the nature or character of the property rather than its grade or quality. It means that real property must be exchanged for real property, but the form of the real estate may vary substantially.
Can Section 1031 be used for personal property exchanges?
As of the Tax Cuts and Jobs Act of 2017, Section 1031 exchanges are limited to real property only. Personal property exchanges no longer qualify.
What is a delayed exchange under Section 1031?
A delayed exchange lets a seller relinquish their property before acquiring a replacement property. The replacement property must be identified within 45 days and acquired within 180 days to qualify under Section 1031.
What is “boot” in a Section 1031 exchange?
“Boot” refers to any additional value received in an exchange, such as cash or non-like-kind property, which is subject to capital gains tax.
Do both properties need to be of equal value in a Section 1031 exchange?
Not necessarily. If there is a difference in value, the receiver of a less valuable property may receive boot to equalize the transaction.
Related Terms
- Boot: Non-like-kind property or cash received in a Section 1031 exchange, which may be subject to capital gains tax.
- Adjusted Basis: The original cost of a property, adjusted for improvements, depreciation, and other factors, used for tax purposes.
- Like-Kind Property: Real estate property of the same nature or character, intended for trade or investment, used in a Section 1031 exchange.
Online Resources
- IRS - Like-Kind Exchanges Under IRC Section 1031
- Investopedia - Section 1031 Exchange
- Realty Mogul – Understanding Section 1031
References
- “Internal Revenue Code: Section 1031,” U.S. Internal Revenue Service.
- Mishkin, Frederic, “Understanding Obligations Under Tax-Deferred Exchanges,” Harvard Law Review.
- Safrai, Yinon, “A Guide on Section 1031 Exchanges,” Journal of Finance and Accounting.
Suggested Books for Further Studies
- “The Book on Tax Strategies for the Savvy Real Estate Investor” by Amanda Han, Matthew MacFarland
- “Starker Exchanges: A Detailed Analysis of the Legal and Tax Requirements of Section 1031” by Jack Cummings
- “Tax-Free Real Estate Investments: Solving the 1031 Puzzle” by Timothy Harris
- “Real Estate Tax Deductions: The Secret to Reducing Your Taxes” by Stephen Fishman J.D.
