Investing in real property with a 1031 exchange can be a lucrative venture; however, an investor can also lose a considerable amount of potential income to capital gains taxes if the purchase and sale of properties is not conducted with care. One option for taxpayers who are trying to avoid paying the often high rate of capital gains taxes is to enter into a Section 1031 Exchange instead of a traditional sale. When a transaction qualifies for Section 1031 treatment, the profits realized as a result of the exchange are deferred for purposes of computing capital gains taxes. Although the general concept behind a Section 1031 Exchange is rather straightforward, an overlooked detail can cost a taxpayer as significant amount of money because a taxpayer who fails to meet each and every requirement for Section 1031 treatment will lose the tax benefits offered by a 1031 Exchange.
The forerunner of the modern day 1031 exchange has traces to when goods and services first were traded. When cowboys traded horses or bulls and the one horse or bull was considered a better value than the one received, a weapon, food or cash was received to settle the difference, often placed in the cowboy’s boot for safekeeping. In today’s 1031 exchange, when the exchangor receives a benefit such as cash at closing or has a smaller mortgage than before, this is known as equity or mortgage boot. In 1921, Congress enacted the National Revenue Act that included the modern day 1031 exchange. The 1031 exchange component was based upon the fact that the economic position of the taxpayer did not change from one transaction to the next. The taxpayer has not received a benefit either in cash or reduction in mortgage, rather an old property has been replaced with another property. If a benefit was received, it is taxable.
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.