1031 Like Kind Exchange Overview
After a normal sale of a property, the property owner is taxed on any profit realized from the sale. However, through a Section 1031 Like Kind Exchange, the tax on the gain can be deferred until some future date. As per Section 1031 of the Internal Revenue Code, no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. Consequently properties like land, building, vehicles, cattle etc. may be traded to get another like-kind property and defer taxes indefinitely. Thanks to this type of ability for deferring taxes, some companies decide to use IRS 1031 like kind exchange techniques every year.
A tax-deferred exchange is a technique through which a property owner exchanges one or more relinquished 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. It must be clearly understood that the 1031 like-kind exchange is tax-deferred and not tax-free. When the replacement property is ultimately sold without any exchange the original deferred gain and any additional gain realized since the purchase of the replacement property, is subject to tax.
1031 Like Kind Exchange Property Types
One of the terms commonly used in the IRS 1031 exchange law is like-kind. Like-kind denotes property type and not the property value. Under 1031 Like Kind Exchange, properties similar in nature only can be exchanged. For example, exchanges are possible between independent residential buildings to apartment buildings, vehicle to vehicle, cattle to cattle etc. This obviously means that building cannot be exchanged to vehicle; car cannot be exchanged for land and so on and so forth. As indicated earlier, there is no restriction on the value of the exchanged property except that in case if the value of exchanged property is less than the property sold it is considered as profit and hence taxed. Hence, it is necessary that the exchange property has to be of equal or higher value to qualify for a 1031 Like Kind Exchange.
Under 1031 Like Kind Exchange there is no problem in purchasing a higher value property using the sale proceeds of the original property. In such a case there is no profit due to the sale of original property since full amount of sale is utilized for purchase of a new property. This means no tax is payable immediately on this sale. However, this tax is deferred. The sale money can fully be utilized for down payment to a new property which allows the person to borrow further and purchase a better property.
Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of:
Inventory or stock in trade
Stocks, bonds, or notes
Other securities or debt
Partnership interests
Certificates of trust
1031 Like Kind Exchange Cautions
Taxpayers must be cautious about individuals marketing improper use of 1031 like kind exchanges. Normally they aren’t tax professionals. Sales pitches often encourage property owners to exchange non-qualifying vacation or second homes. A great many marketers of like-kind exchanges call them “tax-free” exchanges not “tax-deferred” exchanges. Property owners are often advised to claim an exchange even though they have received cash proceeds from the sale of the property which is not allowed under a 1031 Like Kind Exchange.