What is Section 1031?
The Section in the Internal Revenue code has been on the books since 1921. However, in the past the complexities and details of the tax code prevented only the most knowledgeable and sophisticated investors were privy to this option. Fortunately, since the passing of the Omnibus Budget Act in 1990 it has become more main stream. The Act clarified the process an opened this option to a broader set of investors.
Section 1031 Exchanges, has become more popular since the mid-90s, permits investors of real property to defer the tax on capital gains until some point in the future.
For Example let’s say you purchased a rental property ten years ago for $ 60,000 now worth $ 240,000. You could sell the property but you will have to pay capital gains tax, remember you have to recapture all depreciation as well.
The 1031 exchange option permits you to sell and defer tax as long a you identify a “like kind property” within the prescribes time and ultimately close within the allotted time. The new property must be worth more than the one you are selling.
Section 1031 of the Internal Revenue Code states 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. Basically a tax-deferred exchange is a method by which a property owner/investor trades one or more relinquished properties for one or more replacement properties of what is called” like-kind", while at the same time deferring the payment of federal income taxes and some state taxes on the transaction.
The reasoning 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 exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Very important to find an agent that understands the timeline and most importantly the process itself.