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What is a 1031 Tax Exchange?
Section 1031 of the U.S. Internal Revenue Code allows an investor to defer his/her capital gains taxes on the exchange of like-kind properties. In other words, if you exchange business or investment property solely for a like-kind business or investment property, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized. Be aware that Section 1031 does not apply to the exchange of inventory, bonds, stocks, notes, securities or other assets. Like-kind properties, even if they differ in grade or quality, or are improved or unimproved, are those properties that are of the same nature or character.
The obvious advantage of a 1031 Exchange is the ability of a taxpayer to sell income, investment or business property and replace it with like-kind replacement property, avoiding federal income taxes on the transaction. Disadvantages, however, do exist. Section 1031 Exchanges include a reduced basis for depreciation in the replacement property. The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain, which was deferred on the sale of the relinquished property as a result of the exchange. The replacement property thus includes a deferred gain that will be taxed in the future if the taxpayer cashes out of his investment.
There are a number of ways to structure a tax-deferred exchange under Section 1031 of the Internal Revenue Code. However, "safe-harbor" regulations, adopted in 1991, established procedures that include the use of an intermediary, direct deeding, qualified escrow accounts and other procedures that are recommended by the IRS. Therefore, it is a good idea to structure your 1031 Exchanges so that they can be in harmony with the 1991 Regulation, particularly the use of an intermediary with direct deeding.
Of course, 1031 exchanges can occur without the use of an intermediary when the parties to an exchange are willing to exchange deeds or enter into an exchange agreement with each other. However, two-party exchanges are rare.
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What is the Boot Test?