Whenever you sell a business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
As a property owner or business owner, the 1031 Exchange is a powerful investment tool. Property that is sold or transferred for gain can be subject to taxation. Those taxes can add up quickly depending on the type of property, how long it was owned, state taxes, capital gains, depreciation, and the owner’s tax bracket. As a property seller, you may be liable for taxes that add up to 40% or more.
There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like kind property of lesser value. Constructive receipt is when the Exchangor has the right to receive or control funds even though the Exchangor has not yet directly accessed those funds.
The exchange can include like-kind property exclusively or it can include like kind property along with cash, liabilities, and property that are not like kind. If you receive cash, relief from debt, or property that is not like kind, however, you may trigger some taxable gain in the year of the exchange.
1031 Exchange Information and Exchange Basics
We believe it is important for our clients to understand the process they are about to go through before they actually begin. For this reason, we offer details about a series of exchange basics on this page and a wealth of other reference materials on our site.
The exchange must be set up with a Qualified Intermediary (QI) (by execution of certain exchange documents) prior to the sale of the relinquished property. If these documents are not in place prior to closing, the transaction will be treated as a taxable sale and subsequent purchase, rather than an exchange.
Qualified Purpose Requirement
Both the relinquished and the replacement properties must be held for use in the taxpayer's trade or business or for investment purposes. Personal residences are not eligible as relinquished or replacement properties.
Fully Deferred Exchange
In order for the taxpayer to receive a total deferral of gain and the associated tax liability, the taxpayer must: Purchase replacement property that is equal to or greater in value than the relinquished property (fewer exchange expenses); and reinvest all of the equity from the relinquished property into the replacement property, and acquire the only like kind property if any of these requirements are not met, there will be tax consequences. Any cash pulled out by the Taxpayer will be treated as taxable boot.
Same Taxpayer Requirement
The replacement property must be held in the same manner that the relinquished property was held, with a few exceptions. A single-member limited liability company that elects taxation as a sole proprietorship and the single-member are treated as one and the same taxpayer.
Only like kind replacement property will qualify to defer the gain on the relinquished property. However, all real property is considered like kind to all other real property, regardless of whether it is improved or not.
Receipt of Boot
Cash or other non like kind property received in an exchange or debt that is paid off on the relinquished property and not replaced with an equal or greater amount of debt on the replacement property (or offset by the injection of cash) is considered a "boot" and is taxable up to the amount of gain. A taxpayer may receive boot and still be able to defer some of the gains.
"Not all Qualified Intermediaries are created equally. Any non-disqualified person can operate as a QI. Taxpayers should use care in selecting a QI with a good reputation in the industry, experience, nationwide services, and proven financial stability. Granite is committed to making the 1031 tax deferral process streamlined and educational as well as keeping hard-earned tax dollars in your pocket.
Justin Swift CES
Managing Partner & Owner Granite Exchange Services