What is a 1031 Exchange?
A 1031 exchange gets its name from the IRS tax code, section 1031, that allows people or entities to avoid incurring capital gains tax on properties that are being traded for a like investment. So if you have a store in Boston and want to trade it for a commercial property in Wyoming you can do so and avoid taxes on the profits from the transaction.
Using a 1031 is a great way to accumulate wealth especially if you are ready to move a property in an area that has seen extensive appreciation of value.
The Federation of Exchange Accomodators has a very good FAQ on this that I have excerpted.
What is a tax-deferred exchange?
In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
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Comment by Monica on 22 September 2006:
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Comment by William L. Exeter on 6 May 2007:
Great summary article. The reader should also evaluate any accummulated depreciation recapture upon sale. The 1031 exchange allows the investors to keep all of his/her profits invested and growing on their behalf until you sell. The minute you sell and stop exchanging all of the accummulated capital gains and depreciation recapture income tax liabilities will be recognized. It’s what we call swap ’til you drop. Keep exchanging through out your lifetime and you will continuously defer your income tax liabilities and your heir will inherit your properties on a stepped up basis (the capital gain and depreciation recapture income tax liabilities go away at death).