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A 1031 exchange refers to Section
1.1031 of the Internal Revenue Code (IRC).
Section 1.1031 was passed in 1990 and allows the Capital Gains tax
to be deferred until sometime in the future. In a usual real
estate transaction, the property owner is required to make the
payment of a Capital Gains Tax on any realized gain from the sale
of a property, but a 1031 exchange offers a great way to defer
those payments. Let’s look at this more closely.
Sellers utilizing a 1031 Exchange of some real and personal
property allow them the opportunity to avoid paying capital gains
taxes (15%) and state taxes by "exchanging" their sold property
for newly purchased property. Keep in mind that we are dealing
with the IRS, so restrictions apply.
Let’s start with the most important one.
This states that only business property and investment property
are eligible. A purely residential home exchange does not
qualify, although exchanging a property that your business has
used for its office, or even one used simply for investment
diversification, does.
The IRC also requires that you concurrently purchase a property of
"like-kind."
Do not interpret this as if you are selling a 15,000 sf office
that you are required to buy another 15,000 sf office. This
“like-kind” term means nearly any real estate held for productive
use in a business or for investment can be exchanged for any other
property to be used for productive business or investment
purposes. While "like-kind" is an important control, it has been
interpreted so broadly as to give individuals leeway.
One important restriction to understand is that real property in
the United States and real property outside the United States are
not like-kind properties.
It is also important to note that Section 1031 of the IRC does
not apply to exchanges of inventory, stocks, bonds, notes,
other securities or evidence of indebtedness, or certain other
assets.
As you can see, the theory behind a Section 1031 Exchange is: when
a property owner has reinvested his/her sale proceeds into another
property a monetary return has not been realized to incur any tax.
In other words, the taxpayer's investment is still the same, as
only the form has changed (e.g. office exchanged for warehouse).
Hence, the IRS has determined it would be unfair to require a
taxpayer to pay tax on this "paper" gain.
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