Written by attorney Gregory L Fullington

Primer on the 1031 Exchange

Under Internal Revenue Code (IRC) Section 1031, a real property owner can sell his/her property and then reinvest the proceeds in ownership of a like-kind property and defer the capital gains taxes. To qualify as a like-kind exchange, property exchanges must be done in accordance with the rules set forth in IRC 1031, and in the treasury regulations. In a typical transaction, the property owner is taxed on any gain realized from the sale. However, if a 1031 Exchange is utilized, that tax is deferred until a future date. Section 1031 of the IRC states 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 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 thrust behind 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, thus it would be unfair to force the taxpayer to pay tax on a "paper" gain. The like-kind exchange under 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. In a 1031 Like-Kind exchange any real property can be exchanged for any other real property within the United States or its possessions, with certain limitations. Examples include apartments, commercial, condos, duplexes, raw land and rental homes. "Like-Kind" means similar in nature or character, notwithstanding differences in grade or quality. One kind of class of property may not be exchanged for property of a different kind or class. Examples include the following: o apartment building for farm/ranch o office building for hotel o raw land for retail space o unimproved property for commercial property o airplane for airplane Examples of non "Like-Kind" properties include primary residences, stocks and bonds, notes, partnership interests, developed lots held primarily for sale and property to be resold immediately after initial purchase or completion of improvements. The timeline of the 1031 exchange is important. Identification Period: Within 45 days of selling the relinquished property you must identify suitable replacement properties. This 45 day rule is very strict and is not extended should the 45th day fall on a Saturday, Sunday, or legal holiday. Exchange Period: The replacement property must be received by the taxpayer within the "exchange period," which ends within the earlier of . . . 180 days after the date on which the taxpayer transfers the property relinquished, or . . . the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs. This 180-day rule is very strict and is not extended if the 180th day should happen to fall on a Saturday, Sunday or legal holiday. If you have real property that will net you a gain upon sale (generally property that has been substantially depreciated for tax purposes and/or has appreciated in fair market value), then you are exactly the person who should consider a 1031 exchange. There are 5 tax classes of property: 1) Property used in taxpayers trade or business. 2) Property held primarily for sale to customers. 3) Property which is used as your principal residence. 4) Property held for investment. 5) Property used as a vacation home. Section 1031 applies to the first and fourth categories, and potentially the fifth category. Business use is defined as, "To hold property for productive use in trade or business." Property retired from previous productive use in business can be qualifying property. Investment purpose defined as real estate, even if unproductive, held by a non-dealer for future use or increment in value is held for investment and not primarily for sale. Investment is the passive holding of property, for more than a temporary period, with the expectation that it will appreciate. Property held for sale in the immediate future is not held for investment. The longer you own a property before exchanging it, the better. However, there is no safe holding period for property to automatically qualify for an exchange. Keep in mind, the property only need to be "held for investment" for it to be eligible for an exchange. Time of ownership is ONLY one factor at which the IRS looks at when determining if the property was "held for investment". In one private letter ruling (PLR 8429039), the IRS stated that a minimum holding period of two years would be sufficient. Although a private letter ruling does not establish legal precedent for all investors, there are many advisors who believe two years is a conservative holding period, provided no other significant factors contradict the investment intent.

Additional resources provided by the author

IRC 1031

Free Q&A with lawyers in your area

Can’t find what you’re looking for?

Post a free question on our public forum.

Ask a Question

- or -

Search for lawyers by reviews and ratings.

Find a Lawyer