What are the basics of a 1031 Exchange
The 1031 exchange was created with Internal Revenue Code Section 1031(a)(1) which says:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
So what does that really mean?
There are two key terms to that statement above that should be clarified further for complete understanding.
Exchange
The word exchange is important because the transaction must be an exchange and not a sale and a purchase. When doing an exchange you must identify the replacement property following a specific process that has its own set of rules as provided by the IRS.
To be considered an exchange, there is a 45-day time restriction from the sale of the first property to the date that the replacement property is closed on, or at a minimum the replacement property must be formally and unambiguously identified and described. If the replacement property is simply identified by the 45-day deadline, it must be received and the exchange completed within 180 days or by the due date of the income tax return, including extensions, for the tax year in which the initial property was relinquished.
In addition to the time restrictions, when title is taken on the replacement property it must be titled in the same way that the relinquished property was titled.
Like-Kind
The property received in the exchange must be of “like-kind” to the relinquished property. There are volumes of information written on what is considered a like-kind property. Here is an abbreviated definition from the IRS themselves:
“Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However,…personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.”
The bottom line here is that the properties must be considered “like-kind” in order to qualify for 1031 exchange tax treatment. Like just about everything the IRS does, the rules can get complicated, but they do offer a lot of flexibility on what is considered a like-kind property.