Think about a typical transaction where a property owner sells real or personal property. The taxpayer is taxed at the time of the sale for any capital gain or recaptured depreciation realized on the sale of the property. Section 1031 of the Internal Revenue Code offers an alternative to paying this capital gains tax immediately if a replacement property is purchased of equal or greater value than the net sales price. Section 1031 allows a taxpayer to defer the tax due as a result of a sale to a time in the future, so long as certain rules and guidelines are followed. The reasoning behind Section 1031 exchange is that it is thought that the taxpayer shouldn’t be penalized (taxed) on sales proceeds as long as those proceeds are used to invest in a similar property. In effect the taxpayer’s economic position has not changed nor has she/he received a benefit of cash or reduced indebtedness.
Time Requirements
The taxpayer must follow three strict timing deadlines in completing a Section 1031 exchange. The taxpayer must identify and report that he/she intends to complete a Section 1031 exchange before the sale of the initial property. Many Realtor contracts, such as Florida and Washington DC, already have the assignment language embedded in the Purchase and Sale Agreement. Within 45 days of the date of the sale of the initial property, the taxpayer needs to identify a replacement property that he/she intends to purchase, and within 180 days post-closing on the old property, the replacement property transaction must be complete and the taxpayer must be in legal possession of it.
Like-Kind
Real estate is the most common type of property that is exchanged using the Section 1031 exchange. Section 1031 maintains that in order to qualify for a Section 1031 exchange, the property must be like-kind. The general rule is that all real estate is considered like-kind to each other. The other Section 1031 mandate is that both the property being sold and the replacement property must be held for trade or business or as an investment, which means that a taxpayer’s personal residence does not qualify for a Section 1031 exchange.
The best way to understand a Section 1031 exchange is to see an example, which follows.
Kayla has decided to sell her three-story walk-up investment property, which she originally purchased for $400,000. She has found a replacement property that she would also hold as an investment, and the purchase price is $475,000.
Notice that the replacement property is being purchased for more than the sales price of the old property. As a result, Kayla would be eligible to defer 100% of the capital gains tax that would be due from the sale.
On the flip-side, if the replacement property had a purchase price for $350,000, Kayla would only be eligible to defer $350,000, or the amount of the proceeds that were re-invested in the replacement property. A capital gains tax on the $50,000 of sales proceeds not re-invested would be due when filing her federal return using Form 8824.
Benefits
Section 1031 exchanges offer multiple benefits for the taxpayer:
By completing a Section 1031 exchange, the taxpayer has more money available to invest in further property. Think of it as an indefinite, interest free loan from the federal government in the amount of tax that is deferred.
The gain from the recapture of depreciation is postponed along with the tax.
A Section 1031 exchange allows a taxpayer to re-allocate his/her investment portfolio without having to pay a capital gains tax.
If a taxpayer continues to complete Section 1031 exchanges upon the sale of properties, the tax due on the capital gains could potentially be deferred forever or stepped up to their heirs.
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