There is a section in the US Tax Code that deals with an investor being able to sell a property and to reinvest the proceeds in a new property and in the process deferring all capital gains taxes on that sale. This is what is called the IRC section 1031. The tax code states:
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which Is to be held either for productive use in a trade or business or for investment."
Let's look at how an investor who has a $200,000 capital gain on an investment he has sold would end up with a 70,000 tax bill with depreciation recapture and both federal and state taxes. The remaining amount that would be left to reinvest would only be $130.000 which could be used to invest in another property. With a 25% down payment and a 75% loan to value ratio, the seller would only be able to purchase a new property valued at $520,000. However, if that same investor chose to exchange that property with a 1031 he or she would be able to re-invest the full $200,000 of equity and would be able to purchase a property in the range of $800,000 in real estate. With the assumption of the same down payment and loan to value ratio.
This illustrates that exchanges protect the investor from capital gains taxes with resulting portfolio growth and an increase in the return on investment. A thorough knowledge of the exchange process and the IRC are needed to access the full potential of these tax benefits. To enable you to fully understand the key term used here as "like-kind" in the code does not necessarily mean the same exact types of property. This can lead most investors into the possibility of dismissing or overlooking this key point in the code. The resource that will give you accurate and thorough information about the entire exchange process is Asset Preservation.
The exchange can occur with any property held for productive use in a trade or business or for an investment that can be exchanged for a "like-kind" property. As stated before "like-kind" refers to the nature of the investment and not with the form. In other words any kind of investment property can be exchanged for another type of investment property. For example a family residence can be exchanged for a duplex. Undeveloped land can be exchanged for a shopping center or an office building can be exchanged for an apartment complex. Whomever is doing the exchange has the flexibility to change investment strategies as they see fit their need.
There are some things that you cannot trade and this includes trading partnership shares, notes, stocks, bonds, certificates of trust or other such items. Other restrictions are that you cannot trade a personal residence for an investment property or property in a foreign country or offered for sale houses built by a developer called "stock in trade". Investors who buy and flip houses (buy fixer-uppers and sell as soon as they are improved) cannot use 1031 as these houses are considered "stock in trade".
Sometimes when an investor attempts to exchange a property too quickly or trades too many properties during one year, this investor may be considered a dealer and thus the properties could become "stock in trade". If the property is held strictly for investment purposes and the investor can prove this than he could be allowed to use 1031. No clear rules define a dealer but the purpose and motivation for acquiring a property and how long the property is held and the principle business of the owner are things that can differentiate dealers and investors.
If a property is being relinquished and does qualify for a 1031 exchange, the question becomes what will the replacement be. Section 1031 applies to both personal property and real property, but the primary difference is what is the definition of "like-kind".
There are complications and that is why if you are contemplating doing a 1031 exchange make sure you talk to a professional. Some of the things you have to consider are that 1031 exchanges are not for personal use, in other words you can’t swap your primary residence for another home. This provision is only for investment and business property. There are oddities whereby a painting which is personal property can qualify for a 1031 exchange. That is why a tax professional who has dealt with this part of the code would be the best person to guide you through this process.
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