What is a 1031 Exchange?
Anyone who is thinking about selling a business use or investment property and has a gain or taxable recapture should consider the benefits of performing an IRC Section 1031 exchange. Whether the investor's property is owned free and clear or encumbered, the benefits of a tax-deferred exchange can be significant.
Section 1031(a)(1) provides that "no gain or loss is recognized on the exchange of property held for productive use in a trade or business, or for investment, if the property is exchanged solely for property of a "like-kind" that is to be held either for productive use in a trade or business or for investment."
In a 1031 exchange, sometimes called a "tax free exchange," a property owner may dispose of property and acquire another without incurring any immediate tax liability. This allows the taxpayer to keep the "earning power" of the deferred tax dollars working for him or her in another investment. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. But in an exchange, the tax on the transaction is deferred until some time in the future, usually when the newly acquired property is sold.
A 1031 transaction, however, must be structured in such a way that it is, in fact, an exchange of one property for another, rather than the sale of one property and the purchase of another. All requirements of Section 1031 and other sections of the Internal Revenue Code must be carefully met for a valid exchange. Further, the application of Section 1031 to a particular transaction or property can only be determined after careful study of a taxpayer's particular facts and circumstances, and analysis by his or her tax advisor, attorney, real estate agent and intermediary.
Despite all of these rules, well-informed investors complete successful 1031 exchanges every day on very favorable terms. The benefits of deferring taxes on the sale of real estate are important to investors seeking to create, preserve, and build wealth through investment in real estate.