A 1031 Like-Kind Exchange, otherwise known as a tax deferred exchange is a strategy for selling one property and then proceeding with an acquisition of another property within a specific time frame which qualifies for a capital gains tax deferral.

Although the process of selling a property and then buying another property in a 1031 Like-Kind exchange is practically identical to any standard sale and buying situation, a "1031 exchange" is unique because the entire transaction is treated as an exchange and not just as a simple sale. It is this difference between "exchanging" and not simply buying and selling which, in the end, allows the taxpayer to qualify for a deferred gain treatment. In other words, while sales are taxable with the IRS, a 1031 Like-Kind Exchange is not.

In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date. Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax deferred exchange is a method by which a property owner trades 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 transactions.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain. The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another 1031 exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

Any real estate property owner or investor should consider an exchange when he or she expects to acquire a replacement "like kind" property subsequent to the sale of his existing investment property. Anything otherwise could necessitate the payment of a substantial federal and state capital gain tax.

Below is a look at the basic concept, which can apply to all 1031 exchanges. You should understand this concept so that you can completely defer the realized capital gain taxes. The two major rules to follow are:

1. The total purchase price of the replacement "like kind" property must be equal to, or greater than the total net sales price of the relinquished, real estate, property.

2. All the equity received from the sale, of the relinquished real estate property, must be used to acquire the replacement, "like kind" property.

The extent that either of these two rules are violated will determine the tax liability accrued to the person executing the Exchange. In any case which the replacement property purchase price is less, there will be a tax responsibility incurred. To the extent that not all equity is moved from the relinquished to the replacement property, there will be tax. This is not to say that the 1031 exchange will not qualify for these reasons. Keep in mind, partial exchanges do in fact, qualify for a partial tax-deferral treatment. This simply means that the amount, of the difference (if any), will be taxed as a boot or "non-like-kind" real estate property.

Please call us if you would like any additional information on 1031 Like-Kind Exchanges.