💡 What is Internal Revenue Code Section 1031?
Since 1921, Federal tax law under Internal Revenue Code (IRC) section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes, which otherwise would have been due from the sale, are thus deferred. Most 1031 Exchanges involve separate buyers and sellers and are not simple swaps between two parties. Under these circumstances, the use of an independent third party Qualified Intermediary (QI) is necessary to satisfy the “exchange” requirement. The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. 1031 Exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property. In 2018, section 1031 was amended to provide that only real estate is eligible for a 1031 Exchange.
💡 What are 1031 Like-Kind Exchanges?
Like Kind Exchanges, also known as tax-deferred exchanges, are defined by IRC section 1031. Since 1921, section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes which otherwise would have been due from the sale are thus deferred. Section 1031 transactions range from 2-party “swaps” to more complex non-simultaneous 1031 Exchanges involving separate buyers and sellers. Qualifying assets include commercial, agricultural and rental real estate. Tax rules for non-simultaneous exchanges require the use of an independent third party Qualified Intermediary (QI). The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. Section 1031 Exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property.
💡 Does the tax ever go away?
With 1031 Exchanges, taxes are deferred but not eliminated. These legitimate transactions utilize an important tax planning tool. Payment of tax occurs:
upon sale of the replacement asset;
incrementally, through increased income tax due to foregone depreciation; or
by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.
💡 How does depreciation impact exchanges to make section 1031 revenue neutral?
When depreciated real estate is exchanged under section 1031, the gain due to depreciation and any depreciation recapture is not recognized, but rather is rolled into the newly acquired real estate. Depreciation is only allowable for any remaining tax basis and for value representing additional capital investment into a like-kind asset.
For example, let’s assume an investment property has a fair market value of $10x, but it is fully depreciated and has a tax basis of $0. If it was exchanged for replacement property with a value of $10x, that replacement property would have the same tax basis and no further depreciation would be allowed. If the replacement property has a value of $25x, then only $15x, representing the additional investment, would be available for additional depreciation over a new depreciation period. If the relinquished property was not fully depreciated, but had a remaining tax basis of $2x, and the replacement property had a value of $25,000, then the maximum depreciation allowed on the replacement vehicle would be $17x (remaining tax basis plus the additional investment).
The total depreciation expense allowed over the life of property which participates in a 1031 Exchange is no greater than the depreciation expense of property that does not participate in a 1031 Exchange. Section 1031 benefits the taxpayer by permitting immediate reinvestment of the entire amount of sale proceeds into replacement property, rather than just reinvesting the “after tax” proceeds.
💡 Who uses 1031 Exchanges?
All businesses, manufacturers, real estate investors, companies in the construction, trucking, rail, marine and equipment leasing industries, farmers, ranchers, individuals and more make good use of like-kind exchanges. 1031 Like-Kind Exchanges are one of the few incentives available to and used by taxpayers of all sizes. A recent industry survey showed that 60% of exchanges involve properties worth less than $1 million, and more than a third are worth less than $500,000. Qualified Intermediaries (QI) facilitate non-simultaneous tax-deferred exchanges of investment and business use properties for taxpayers of all sizes, from individuals of modest means to high net worth taxpayers and from small businesses to large entities.
