1031 Exchange Definition
Posted by Andy Gustafson on Thu, Jan 12, 2012
For those not familiar or a bit rusty, this article looks at the 1031 exchange definition including what, when, why and how of Internal Revenue Code (IRC) Section 1031 tax deferred exchanges. The Internal Revenue Service refers to 1031 exchanges as tax-free exchanges because the outcome in the year a 1031 exchange concludes is that no gain or loss is recognized meaning that no tax is paid.
1031 Exchange Definition
The 1031 exchange definition from the IRC perspective is no gain or loss is recognized when property held for productive use in a business, trade or investment is exchanged for like-kind property held for productive use in a business, trade or investment. No tax is recognized or paid on property sold and replaced with property of equal or greater value. The federal and state capital gains and recaptured depreciation tax is deferred, postponed until the replacement property sells, when another exchange can be initiated. Taxes can represent as much as 40 percent of the sale in some states.
When
A 1031 exchange is affected prior to or at the property closing. A 1031 exchange cannot be initiated once the closing passes. Often, a potential client will call to ask what can be done after the sale and replacement have been completed. There is nothing except pay the federal, state capital gains and recaptured depreciation tax and be prepared next time.
Why
When a property held for the proper intent in a trade, business or investment is exchanged for a property with like-kind intent of equal or greater value, no tax is recognized. The premise is that no tax is paid when the economic position of the taxpayer is the same after the exchange as before. The taxpayer received no benefit from the transaction other than replacing one asset for another. If a benefit is received, such as cash or reduction in debt otherwise known as equity or mortgage boot respectively, a tax is triggered on the boot received.
In a partial 1031 exchange, if the price less selling expenses is less than the acquisition price plus purchase expenses, a tax is paid on the difference. The tax will never be more in a partial 1031 exchange than if a 1031 exchange was not initiated. The rule of thumb is if the boot or cash received or debt not replaced is greater than the capital gain, then a 1031 exchange most likely does not make sense. Another rule is cash can offset debt, but debt does not offset cash.
How
To get started, contact your CPA to determine the recognized gain or tax due from selling the asset. Deferring the tax is the primary reason why taxpayers initiate 1031 exchanges. Next, contact a Qualified Intermediary, preferably a Certified Exchange Specialist®. They will walk you through the steps to a 1031 exchange and defer the tax. There two 1031 exchange strategies: a forward and a reverse.
To learn what issues to consider when evaluating a 1031 exchange, download the complimentary “Taxpayer 1031 Exchange Like-Kind Checklist.”
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