The IRS Code 1031 Exchange allows investors to defer or potentially avoid paying tax on capital gains incurred by the sale of a property. By exchanging one property for another “like-kind” property, an investor can preserve capital by deferring tax that might be owed until the investor reaches a more favorable tax environment, such as a lower tax bracket in retirement or more beneficial tax rates by legislation.
The code sounds simple enough, but the IRS has identified loopholes and guards against outright tax avoidance by instituting certain restrictions. You will most likely need to use a licensed CPA that has passed the CPA exam.
The most obvious restriction is commonly pitched by sales individuals to deceive taxpayers into conducting “tax-free” exchanges, when it is in fact not allowed. The IRS does not recognize any personal property, such as a vacation home or cabin, as a qualifying 1031 exchange property. All properties involved in the exchange must be owned and productively used for business or investment. If personal property is found to be used in the exchange, any capital gains deferred or avoided in the exchange become immediately taxable to the parties involved.
The IRS code stipulates that the properties exchanged must be “like-kind” meaning of similar nature, character or class. Although this can be open for interpretation, the IRS clearly restricts exchanging one property owned in the United States for a property owned outside of the United States, even if the property meets the “like-kind” definition. Both properties must be located in the country.
One simple restriction that can upset a smooth exchange is that no party may take possession of cash proceeds from the sale prior to the exchange. If this occurs, the capital gains are immediately taxable.
The IRS instituted a restriction to close a widely abused loophole where property owners were following all of the 1031 exchange rules, but they fall under the “Related Parities” definition. The IRS stipulates that if a 1031 exchange occurs between two related parties, which include family members, corporations, partnerships and trusts, the properties must be held for a minimum of two years. If either property is disposed of prior to the two-year holding period, the deferred capital gains must be recognized on the disposal date. The only way out of this rule is death, involuntary seizure or proof that both parties were not just trying to avoid taxes.
While the IRS 1031 Code can be a beneficial tool, beware of these pitfalls when transacting this exchange.