Internal Revenue Code Section 1031 - Section 1031 Like-Kind Exchanges

Section 1031 Like-Kind Exchanges

Section 1031(a) of the Internal Revenue Code (26 U.S.C. § 1031) states the recognition rules for realized gains (or losses) that arise as a result of an exchange of like-kind property held for productive use in trade or business or for investment. It states that none of the realized gain or loss will be recognized at the time of the exchange.

It also states that the property to be exchanged must be identified within 45 days, and received within 180 days.

1031(b) states when like-kind property and boot can be received. The gain is recognized to the extent of boot received.

1031(c) covers cases similar to those in 1031(b), except when the transaction results in a loss. The loss is not recognized at the time of the transaction, but must be carried forward in the form of a higher basis on the property received.

1031(d) defines the basis calculation for property acquired during a like-kind exchange. It states that the basis of the new property is the same as the basis of the property given up, minus any money received by the taxpayer, plus any gain (or minus any loss) recognized on the transaction. If the transaction falls under 1031(b) or (c), the basis shall be allocated between the properties received (other than money) and for purposes of allocation, there shall be assigned to such other property, an amount equivalent to its Fair Market Value at the date of the exchange.

1031(e) stipulates that livestock of different sexes do not qualify for like kind exchange.

1031(h)(1) stipulates that real property outside the United States and real property located in the United States are not of like kind.

The sale of the relinquished property and the acquisition of the replacement property do not have to be simultaneous. A non-simultaneous exchange is sometimes called a Starker Tax Deferred Exchange (named for an investor who challenged and won a case against the IRS). See Starker v. United States, 602 F.2d 1341, 79-2 U.S. Tax Cas. (CCH) paragr. 9541, 44 A.F.T.R.2d 79-5525 (9th Cir. 1979). For a non-simultaneous exchange, the taxpayer must use a Qualified Intermediary, follow guidelines of the Internal Revenue Service, and use the proceeds of the sale to buy more qualifying, like-kind, investment or business property. The replacement property must be “identified” within 45 days after the sale of the old property and the acquisition of the replacement property must be completed within 180 days of the sale of the old property.

Section 1031 is most often used in connection with sales of real property. Some exchanges of personal property can qualify under Section 1031. Exchanges of shares of corporate stock in different companies will not qualify. Also not qualifying are exchanges of partnership interests in different partnerships and exchanges of livestock of different sexes. However, as of 2002 IRS ruling (see Tenants in common 1031 exchange), Tenants in Common (TIC) exchanges are allowed. For real property exchanges under Section 1031, any property that is considered "real property" under the law of the state where the property is located will be considered "like-kind" so long as both the old and the new property are held by the owner for investment, or for active use in a trade or business, or for the production of income.

In order to obtain full benefit, the replacement property must be of equal or greater value, and all of the proceeds from the relinquished property must be used to acquire the replacement property. The taxpayer cannot receive the proceeds of the sale of the old property; doing so will disqualify the exchange for the portion of the sale proceeds that the taxpayer received. For this reason, exchanges (particularly non-simultaneous changes) are typically structured so that the taxpayer's interest in the relinquished property is assigned to a Qualified Intermediary prior to the close of the sale. In this way, the taxpayer does not have access to or control over the funds when the sale of the old property closes.

At the close of the relinquished property sale, the proceeds are sent by the closing agent (typically a title company, escrow company, or closing attorney) to the Qualified Intermediary, who holds the funds until such time as the transaction for the acquisition of the replacement property is ready to close. Then the proceeds from the sale of the relinquished property are deposited by the Qualified Intermediary to purchase the replacement property. After the acquisition of the replacement property closes, the Qualifying Intermediary delivers the property to the taxpayer, all without the taxpayer ever having "constructive receipt" of the funds.

The prevailing idea behind the 1031 Exchange is that since the taxpayer is merely exchanging one property for another property(ies) of “like-kind” there is nothing received by the taxpayer that can be used to pay taxes. In addition, the taxpayer has a continuity of investment by replacing the old property. All gain is still locked up in the exchanged property and so no gain or loss is "recognized" or claimed for income tax purposes.