The capital gain tax implications on the sale of real or personal property held in the productive use of a business or held for investment can be quite substantial, often bringing into question whether or not the sale is still beneficial to the Taxpayer. A Section 1031 like kind exchange (dubbed after Section 1031 of the Internal Revenue Code) is intended to delay the tax on a capital gain to a time in the future. Here is what a person contemplating a 1031 exchange should know.
1031 Like Kind Exchange
Section 1031 of the Internal Revenue Code 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 the property of like kind which is to be held for productive use in a trade or business or for investment.”
The timing of a 1031 is very important. While it is possible to complete the exchange simultaneously, more often than not, especially with real estate, it may take some time to complete the transaction. This is known as a deferred exchange. Once the original property is sold, the Exchangor has 45 days to identify and notify an appropriate party of a replacement property. An appropriate party would be a person involved in the transaction, such as the Qualified Intermediary engaged to accommodate the 1031 exchange. Notification must be in writing and signed and dated. 180 days following the sale of the original property, the Exchangor must complete the exchange and be in possession of the new property. These dates do have some stipulations, but these hard-and-fast time periods should be noted.
Who and What Qualifies
The most important aspect to keep in mind is that the property exchanged must be held for business, trade, or investment. Personal property can also be exchanged. Owners of business or investment property can quality for a like kind exchange, which includes S Corporations, C Corporations, individuals, LLC’s, partnerships, trusts, individuals, and more. The like kind exchange concept limits exchanges to property that is like-kind. As a guideline, most real estate is considered like-kind with other real estate, but personal property such as vehicles, equipment, artwork, gold and silver are more strict on the definition of like kind. It’s important not to assume two pieces of property are like kind. Certain property does not qualify for the like kind exchange, including stocks, bonds, notes, inventory, primary residence and partnership interests.
1031 Like Kind Exchange Intent
The intent behind the 1031 like kind exchange is fairly straight-forward. When the proceeds from the sale of property are reinvested in a new like kind property, the Exchangor doesn’t realize an economic gain from those proceeds; the Exchangor merely replaces their existing property. When the Exchangor finally sells but does not exchange the property in the future, tax will be due on the original basis plus the deferred gain from the first property sold.
A Simple Example of a 1031 Like Kind Exchange
Consider John, a property owner who holds an investment property who wants to sell it and replace it with another investment property. John decides to complete a 1031 like kind exchange and sells his existing property for $500,000. Simultaneously, he purchases a like kind investment property for $700,000. John would not be required to pay the federal and state capital gain tax at the time he completed the transaction. Instead, once he sold that $700,000 property, he would owe tax on the purchase price plus any realized gain. Now consider John buying a new property at $300,000. Because he sold the original land for $500,000, he would be required to pay a capital gain tax on $200,000, while delaying the tax on the $300,000 otherwise known as a partial exchange.
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