Thanks to IRC Section 1031, a properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 (a)(1) states:
“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.”
Taxpayers can defer any capital gains taxes otherwise due from the sale of business property by reinvesting the proceeds in similar property as part of a qualifying 1031 like-kind exchange. One example of a like-kind exchange is trading in one car for another. However, many taxpayers also participate in like-kind exchanges for real property.
Who qualifies? Owners of investment and business property may qualify for a §1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under §1031.
What qualifies? Both the relinquished property you give up and the replacement property you acquire must meet certain requirements. Both properties must be held for use in a trade or business or for investment, and must be similar enough to qualify as “like-kind.”
Real property and personal property can both qualify as exchange properties under §1031, but real property can never be like-kind to personal property.
What doesn’t qualify? Certain types of property are specifically excluded from §1031 treatment, including:
• Inventory or stock in trade.
• Stocks, bonds or notes.
• Other securities or debt.
• Partnership interests.
• Certificates of trust.
Please note: With like-kind exchanges, gain deferral is mandatory unless the taxpayer fails the like-kind exchange rules. Failure often results when the taxpayer closes on one deal, accepts the money from the deal and then goes on to purchase another property using the proceeds. To avoid this type of situation, you should let a qualified intermediary hold the money instead of accepting it.