Section 1031 Exchange

A Section 1031 Exchange can let investors defer taxes that would have been payable on capital gains until a later date.

Effectively this means that a property investor who trades an investment property for one or more similar properties for investment use can then defer the payment of income taxes to the federal government and even defer some state taxes. This is effective for any asset classified as ‘real property' as long as it's used for investment purposes, active use in a trade or business or for the production of income.

The logical basis behind the IRS allowing investors to use the Section 1031 Exchange is that the investor has sold a property and then reinvested the sale proceeds back into a buying a new property. The investor never actually received the sale proceeds in a form that gives the person any funds so the IRS doesn't classify the capital gains as being taxable income.

Section 1031 Exchange put simply means that as long as the tax payer is exchanging one investment property for another property or properties or a like-kind then the IRS consider that the person hasn't received anything that could be used to pay taxes with.

The capital gain has been transferred from one asset to the next, so the IRS doesn't recognize any gain or loss as being part of your taxable income.

Please don't make the mistake of thinking that the Section 1031 Exchange means the same thing as ‘tax-free'. The fact remains that the tax you would have paid is deferred until such time as you do eventually sell the property you bought as a replacement for the first investment you sold.

At the point in the future where you do sell the replacement property then you should be aware that you will be taxed on the original capital gain that you deferred plus you'll also be taxed on the additional gain you may have realized sing you first bought that property as well.

Of course, if you decide never to sell then you can effectively continue to defer any tax that would have been payable on the original capital gain for as long as you retain ownership.

The Section 1031 Exchange is not just used to defer taxes on capital gains for real estate. Stocks and bonds can also be exchanged, but the IRS code does state that the exchange must be between like-kind property.

Exchanging shares of corporate stock in different companies doesn't qualify. This means that if you sell one stock you'll need to exchange it for more of the same stock to take advantage of the Section 1031 Exchange and defer the tax on any capital gain you might have realized.

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Section 1031 Exchange

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Section 1031 Exchange

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