The IRS Section 1031 Like-kind Exchange

Real Estate Transaction - 1031 Like-kind Exchange

In a regular real estate transaction, the owner of business or investment property is taxed on any gain (a capital gain) realized from the sale. However, through a Section 1031 Exchange, the tax on the capital gain is deferred until some future date.

Internal Revenue Code Section 1031 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. In a tax-deferred exchange, the property owner trades one or more properties they own (‘relinquished properties”) for one or more new properties (“replacement properties) of "like-kind.” In doing so, the property owner defers the payment of federal capital gains taxes. The deferred capital gains can be ultimately eliminated by holding the property (or other replacement property) to death, at which time there is a step up in basis (IRS Section 1014b) and no capital gains are owed by your estate or heirs or changing the business/investment property into personal property by using it as a primary residence for two years.

The government reasoning behind the deferral of taxes in these transactions is that the property owner has reinvested the sales proceeds from the original property, including the profit upon which capital gains taxes would be due, into another property. The owner still has the funds invested and has not realized any of the gain, so the taxes on the gain are deferred until the gain is realized. The tax basis of the original property (i.e. the original purchase price) is transferred to the new property, so ultimately the total gain is taxed. 1031 like kind exchanges are transactions that defer taxes, they do not make them tax free transactions.

Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.

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