Section 1031 Tax Exchange
- Last Updated: Tuesday, 21 April 2020
Owners of rental property, or property used for business purposes, should be familiar with Section 1031 of the Internal Revenue Service (IRS) Code, which states that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business, or for investment, so long as the property is exchanged for like kind.
What is a Section 1031 Tax Exchange?
The above is quite a statement, and before explaining this topic in more detail, it’s important to understand there are many exceptions to the Section 1031 tax exchange provision. For example, stocks, bonds, and other securities are not eligible; however, real estate qualifies under this law.
Under Section 1031 of the Internal Revenue Code, anyone that sells or exchanges certain types of property, can defer a capital gain or loss. This mechanism allows individuals to defer paying federal income taxes on capital gains.
Tax Exchange Basics
This tax provision doesn’t apply to someone’s home or personal residence. It’s referring to property used in a business setting; property held for investment purposes.
Exchanged properties must be “like kind.” This means real property for real property, but not necessarily limited to land for land or a rental house for another rental house. The term “like-kind” is referring to personal property of the same character or nature, even if the quality of the property is different.
The sale of a single property does not limit the seller from exchanging multiple properties. The reverse is also true: the seller can dispose of multiple properties in order to purchase a single property. To gain the maximum benefit from this exchange, the price paid for the replacement property must be higher than the price received for the sale.
The term “boot” is used to describe excess value of “other” types of property received in the exchange. To avoid a capital gain, all property needs to be exchanged for “like kind.” The tax code is very specific in this regard. If boot is received, the taxpayer will realize a capital gain on the value of that property. The two most common types of boot include:
- Cash Boot: the difference between the cash received during the sale and that paid for the new property.
- Mortgage Boot: also known as debt boot, this occurs when the amount of debt needed to finance the purchase of the replacement property is less than the remaining principal on the property sold.
The above typically happens when the investor “trades-down,” and the replacement property is worth less than the property sold. In practice, all of the incoming and outgoing funds involved in the exchange flow through a “Qualified Intermediary,” also referred to as a “Facilitator.”
Section 1031 allows for two basic types of exchanges: like-kind exchanges and deferred exchanges. A like-kind exchange is simply a simultaneous closing exchange in which the offered and selected properties must be similar.
A deferred exchange is used more extensively in the private sector for holdings such as real estate investment property. A deferred exchange takes place when the cash from a property acquisition goes from the escrow to the Qualified Intermediary and then the replacement property is purchased in the exchange person’s name.
The replacement property must be identified within 45 days after the property sale is recorded in the county office, and then purchased within 180 days. The process takes place in three steps:
- Property Sale: Before the sale of the first property, the person selling the property must add certain language into the Contract for Sale. Additional documentation is prepared by the Qualified Intermediary. On closing, the proceeds from the sale are delivered directly to the Qualified Intermediary.
- Replacement Property Identification: The person that has just sold personal property must identify the replacement property within 45 days following the initial property sale. The seller usually identifies up to three potential replacement properties.
- Replacement Property Purchase: The person selling the original property now must purchase a replacement property within 180 days after the original property sale. At the closing, money is paid by the Qualified Intermediary, and the Deed to the replacement property is transferred to the client.
The Section 1031 tax exchange mechanism allows investors some flexibility in selling their real estate investments without having to worry about paying taxes; at least in the short term. This process enables taxpayers to defer paying income taxes by avoiding a capital gain on the property.
Investors that have made money in the real estate market can change their real estate investment holdings, and continue to shelter any taxes due on their gains, by taking advantage of the provisions of Section 1031.
About the Author – Section 1031 Tax Exchange