Understanding 1031 Exchanges

Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.

Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale.  IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.  Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.

To qualify for tax-deferred exchange treatment under Section 1031, the relinquished property must be exchanged for replacement property that is of “like-kind.”  This includes both real property and personal property.  For real property exchanges, the term “like-kind” refers to the nature or character of the property, not to its grade or quality.  For example, it does not matter whether the real property being sold or purchased is improved or unimproved because that fact only relates to the grade or quality and not to its kind or class.  In essence, all real property is “like-kind” with all other real property.

The 1031 exchange rule also lays down a guideline for the proceeds of the sale.  The proceeds from the sale must go through the hands of a “qualified intermediary” (QI) and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.  The entire cash or monetary proceeds from the original sale have to be reinvested towards acquiring the new real estate property, and any cash proceeds retained from the sale are taxable.

The theory 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.  Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.

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.
Please do not use this source as legal advice in the matter of 1031 Exchanges.  It is always wise to consult a tax professional or your CPA for proper assistance.