A Section 1031 exchange, commonly known as a like-kind exchange, is a transaction under the of the Internal Revenue Code that allows owners of investment or business real estate to defer certain taxes when selling property and reinvesting the proceeds into other qualifying real property. It is most commonly used by real estate investors and property owners with low tax basis, for whom an outright sale would otherwise trigger capital gains tax and depreciation recapture. By exchanging rather than selling, taxpayers may defer recognition of these taxes while maintaining continuity of investment in real estate.
Section 1031 exchanges are frequently used as part of long-term real estate investment and estate-planning strategies. Because the exchange defers, rather than eliminates, tax liability by carrying forward the taxpayer’s adjusted basis, investors may continue exchanging properties over time. If the property is held until death, the deferred gain may be eliminated through a step-up in basis under U.S. tax law, a feature that has made Section 1031 exchanges particularly common among long-term property owners seeking to defer taxes across generations.
Before 2018, section 1031 also applied to certain exchanges of personal property, but the Tax Cuts and Jobs Act of 2017 limited nonrecognition treatment to exchanges of real property.
Summary To qualify for section 1031 treatment, both the relinquished property and the replacement property must be real property held for productive use in a trade or business or for investment, and not held primarily for sale. Properties are of like kind if they are of the same nature or character, even if they differ in grade or quality; in general, most interests in real property in the United States are treated as of like kind to one another.
Real properties generally are of like kind, regardless of whether the properties are improved or unimproved.See, e.g., However, a real property within the United States and a real property outside the United States would not be like-kind properties. Generally, "like kind" in terms of real estate, means any property that is classified real estate in any of the 50 U.S. states or Washington, D.C., and in some cases, the U.S. Virgin Islands.
Taxpayers who hold real estate as inventory, or who purchase real estate for re-sale, are considered "dealers". These properties are not eligible for Section 1031 treatment. However, if a taxpayer is a dealer and also an investor, he or she can use Section 1031 on qualifying like properties. Personal use property will not qualify for Section 1031.
Taxpayers may wonder whether items such as equipment used on a property are included in the lump-sum sale of the property, and whether recognition of related gains may be deferred. Under Treasury regulation §1.1031(k)-1(c)(5)(i), property that is transferred together with the larger item of value that does not exceed 15% of the fair market value of the larger property does not need to be identified within the 45-day identification period, but still needs to be exchanged for like kind property to defer gain.
Cash to equalize a transaction cannot be deferred under Code Section 1031 because cash is not of like kind. This cash is called "boot" and the gain, to the extent of the receipt of this cash, is taxed at ordinary income tax rates.
If liabilities assumed by the buyer exceed those of the seller (taxpayer), the realized gain of the seller will be recognized. If, however, the seller assumes a greater liability than the buyer, the realized loss cannot offset any realized and recognized gain of receiving boot such as cash or other personal property considered boot.
Originally, 1031 cases needed to be simultaneous transfers of ownership. But after the rendering of the decision in Starker v. United States, a contract to exchange properties in the future is practically the same as a simultaneous transfer. This case invented the concept of the Starker exchange. It is under this case, decided in 1979, that the rules for election of a delayed 1031 originated. To elect the 1031 recognition, a taxpayer must identify the property for exchange before closing, identify the replacement property within 45 days of closing, and acquire the replacement property within 180 days of closing. A Qualified Intermediary must also be used to facilitate the transaction, by holding all the profits from the sale, and then disbursing those monies at the closing, or sometimes for fees associated with acquiring the new property.
Section 1031 like-kind exchanges Section 1031(a) of the Internal Revenue Code () states the recognition rules for realized gains (or losses) that arise as a result of an exchange of like-kind property held for productive use in trade or business or for investment. It states that none of the realized gain or loss will be recognized at the time of the exchange.
It also states that the property to be exchanged must be identified within 45 days, and received within 180 days.(a)(3).
1031(b) states when like-kind property and boot can be received. The gain is recognized to the extent of boot received.
1031(c) covers cases similar to those in 1031(b), except when the transaction results in a loss. The loss is not recognized at the time of the transaction, but must be carried forward in the form of a higher basis on the property received.
1031(d) defines the basis calculation for property acquired during a like-kind exchange. It states that the basis of the new property is the same as the basis of the property given up, minus any money received by the taxpayer, plus any gain (or minus any loss) recognized on the transaction. If the transaction falls under 1031(b) or (c), the basis shall be allocated between the properties received (other than money) and for purposes of allocation, there shall be assigned to such other property, an amount equivalent to its fair market value at the date of the exchange.
1031(e) stipulates that livestock of different sexes do not qualify for like-kind exchange.
1031(h)(1) stipulates that real property outside the United States and real property located in the United States are not of like kind.
The sale of the relinquished property and the acquisition of the replacement property do not have to be simultaneous. A non-simultaneous exchange is sometimes called a Starker tax-deferred exchange, named for an investor who won a case against the Internal Revenue Service (IRS).
For a non-simultaneous exchange, the taxpayer must use a Qualified Intermediary, follow guidelines of the IRS, and use the proceeds of the sale to buy qualifying, like-kind, investment or business property. The replacement property must be "identified" within 45 days after the sale of the old property and the acquisition of the replacement property must be completed within 180 days of the sale of the old property.
As of 2018, Section 1031 can only be used in connection with sales of real property. Prior to the 2018 tax law changes, exchanges of personal property could qualify under Section 1031. Exchanges of shares of corporate stock in different companies did not qualify. Also not qualifying were exchanges of partnership interests in different partnerships and exchanges of livestock of different sexes. However, as of a 2002 IRS ruling (see tenants in common 1031 exchange), tenants-in-common (TIC) exchanges are allowed. For real property exchanges under Section 1031, any property that is considered "real property" under the law of the state where the property is located will be considered "like-kind" so long as both the old and the new property are held by the owner for investment, or for active use in a trade or business, or for the production of income.
In order to obtain full benefit, the replacement property must be of equal or greater value, and all of the proceeds from the relinquished property must be used to acquire the replacement property. The taxpayer cannot receive the proceeds of the sale of the old property; doing so will disqualify the exchange for the portion of the sale proceeds that the taxpayer received. For this reason, exchanges (particularly non-simultaneous changes) are typically structured so that the taxpayer's interest in the relinquished property is assigned to a Qualified Intermediary prior to the close of the sale. In this way, the taxpayer does not have access to or control over the funds when the sale of the old property closes.
At the close of the relinquished property sale, the proceeds are sent by the closing agent (typically a title company, escrow company, or closing attorney) to the Qualified Intermediary, who holds the funds until such time as the transaction for the acquisition of the replacement property is ready to close. Then the proceeds from the sale of the relinquished property are deposited by the Qualified Intermediary to purchase the replacement property. After the acquisition of the replacement property closes, the Qualified Intermediary delivers the property to the taxpayer, all without the taxpayer ever having constructive receipt of the funds.
The prevailing idea behind the 1031 exchange is that since the taxpayer is merely exchanging one property for another property (or more) of "like-kind", there is nothing received by the taxpayer that can be used to pay taxes. In addition, the taxpayer has a continuity of investment by replacing the old property. All gain is still locked up in the exchanged property and so no gain or loss is recognized or claimed for income tax purposes.
Boot Although the term "boot" does not appear in the Internal Revenue Code, it is commonly used to describe money and the fair market value of other non–like-kind property received by the taxpayer in an exchange. To the extent a taxpayer receives boot, gain is recognized up to the amount of boot received.
There are many ways for a taxpayer to receive boot, even inadvertently. The most common sources of boot include:
Cash boot taken from the exchange. This will usually be in the form of "net cash received", or the difference between cash received from the sale of the relinquished property and cash paid to acquire the replacement property (or properties). Net cash received can result when a taxpayer is "trading down" in the exchange, when the sale price of replacement property is less than that of the relinquished. Debt reduction boot, which occurs when a taxpayer's debt on replacement property is less than the debt which was on the relinquished property. As with cash boot, debt reduction boot can occur when a taxpayer is trading down in the exchange. Debt reduction can be offset with cash used to purchase the replacement property. Sale proceeds being used to pay non-qualified expenses, such as service costs at closing which are not closing expenses. If proceeds from the sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer had received cash from the exchange, and then used the cash to pay these costs. Excess borrowing to acquire replacement property. Borrowing more money than is necessary to close on replacement property will not result in the taxpayer receiving tax-free money from the closing. The funds from the loan will be the first to be applied toward the purchase. If the addition of exchange funds creates a surplus at the closing, all unused exchange funds will be returned to the Qualified Intermediary, presumably to be used to acquire more replacement property. Non-like-kind property which is received from the exchange, in addition to like-kind property (real estate).
Section 1031 and second residences