As the precursor to the modern day 1031 tax exchange, exchanging one property for another represents a common activity dating back to when mankind first began trading including the last three hundred years in the US, where land traded for land, and the horse for horse trades of old. If a farmer traded land with a better yield for a farm or land of lessor value, the farmer would ask for something of value to make up the difference. The generally accepted concept was that the farmer’s economic position didn’t change. The theory is the basis for the 1031 tax exchange, yet with the introduction of income taxes in the early twentieth century, any benefit received beyond the real or personal property received was considered boot, or taxable.
Section 1031 of the Internal Revenue Code
“No gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.”
No gain or loss shall be recognized implies that the tax obligation triggered by the sale of property is not due, rather deferred indefinitely as long as property of equal or greater value is acquired. The tax obligation does not go away unless the taxpayer dies and the basis is stepped up to their heirs. Or, if the investment property is later converted to a primary residence and sold, the capital gain is absorbed by the Section 121 $250,000/$500,000 exclusion. Recaptured depreciation and the years property is held for rental prior to conversion are not eligible.
Property held for productive use in a trade, business or investment is any type of real or personal property. Personal use must be minimal. In the case of a vacation property, Section 280A(d) limits the taxpayer’s overnight usage to fourteen overnights per year, not including days on site performing maintenance. Aircraft must be used in a trade or for business. Vintage cars, artwork and collectibles must be held for investment with records supporting the intent. Real estate in India can be exchanged for property either in India or any real property located outside the US and the federal capital gains tax deferred.
Examples of property not eligible for a 1031 tax exchange includes:
- Primary residence
- Notes and Indebtedness
- Inventory
- Stocks, bonds and securities
- Partnership Interests
1031 Tax Exchange Benefit
By deferring the federal and state capital gains and recaptured depreciation tax, the tax that would otherwise have been paid to the Internal Revenue Service is used towards the purchase of replacement property. The deferral represents an indefinite interest free loan due when the replacement property is sold or deferred again in another 1031 exchange. More importantly, the taxpayer is able to relocate their investment to achieve:
- Cash flow
- Depreciation
- Appreciation
- Consolidation
- Diversification
Many taxpayers including timber real estate investment trusts (REITs) such as Weyerhaeuser or Plum Creek, use the 1031 tax exchange to replace timberland with higher yielding tracts or adjacent property to achieve economies of scale operating efficiencies. Car and equipment rental companies use 1031 exchanges to replace their aging fleets with newer assets in what are known as Program Exchanges.
1031 Tax Exchange Example
A common example of a 1031 exchange is a taxpayer selling a business jet such as a Cessna Citation or Hawker Beechcraft. The acquired replacement aircraft has a purchase price equal to or greater than the older aircraft’s net selling price or a tax is due on the balance. The sales price is typically lower than the original purchase price, there is no appreciation; however, the tax due is 25 percent of the depreciation, known as recaptured depreciation, which can represent a five to six figure. Given the taxpayer’s intent is to replace with like kind property or another aircraft, the tax can be deferred as long as the series of 1031 exchange rules are meticulously followed.
To receive a Ten Point Checklist for 1031 Exchanges, click the button below and receive the eBook within seconds.
