1031 exchange

Tax-Free Exchange

Under Section 1031 of the Internal Revenue Code, the exchange of two assets of like kind, even if of different quality, that are used for a business or for investment purposes. The goods exchanged are not assessed capital gains taxes. More precisely, capital gains taxes are deferred until an asset is resold with no intention of reinvestment. Tax-free exchanges also apply if one sells an asset with the intention to use the proceeds to buy a similar asset. For example, if a farmer sells his farm and uses the money to buy another farm, capital gains taxes are likely deferred on the money he made on the sale of the first farm. The same would be true if the he traded farm for farm.

---

1031 exchange

(pronounced “ten thirty-one exchange”) From Section 1031 of the Internal Revenue Code, the ability to exchange like-kind property and defer paying taxes on the gain realized.Under normal circumstances,if a party purchases Blackacre for $10,000 and then exchanges it for $100,000 in cash,there is a gain of $90,000 on which income taxes must be paid.But,because of §1031,if Blackacre is exchanged for like-kind property,then the gain is realized (meaning it occurs) but is not recognized (meaning no tax is due at that time).

The property given up is called the relinquished property, and the property received is called the replacement property. After the exchange, the basis in the relinquished property becomes the basis in the replacement party. In other words, the $10,000 purchase price for Blackacre, called the basis, becomes the basis of the replacement property. When the replacement property is sold later for $150,000, the gain would be $150,000 less $10,000, not $150,000 less $100,000. That is true unless you do another 1031 exchange at that time. There is currently no limit on the number of exchanges you can do in a lifetime.

The properties must be qualifying use properties, meaning that they have or will be held for income production (rental) or investment, or used in a trade or business. Personal residences and vacation homes are not qualifying properties.

Swapping properties is a very handy tax tool, but it is relatively rare to find property owners who want to exchange properties at a simultaneous closing. As a result, the IRS allows the use of a fiction, a type of like-kind property proxy. In the fiction, the owner of Blackacre may sell it for cash, but the money must be placed in the hands of a qualified intermediary to hold. It is said the taxpayer can never have his or her fingerprints on the cash—not to spend, not to borrow against, nothing. The taxpayer then has 45 days to identify a replacement property and complete a form with the identification information. After that, the taxpayer has a short time to close on the replacement property, for which the funds in the hands of the qualified intermediary may be used. If all this is done exactly right, the taxes will be deferred.