What Is Section 1031?
Section 1031 is a provision of the Internal Revenue Code (IRC) that allows a business or the owners of investment property to defer federal taxes on some exchanges of real estate.
The provision is used by investors who are selling one property and reinvesting the proceeds in one or more other properties. It is not available to buyers or sellers of personal homes for their own use.
Qualifying Section 1031 exchanges are called 1031 exchanges, like-kind exchanges, or Starker exchanges. Section 1031 is sometimes known as the Starker Loophole.
- Section 1031 allows investors in business properties to defer taxes on the profits of properties sold in order to raise cash to purchase other properties.
- It is sometimes called the Starker Loophole because the sale and purchase do not need to be simultaneous to qualify for the tax deferral.
- The Section 1031 benefit is not available to sellers or buyers of personal homes.
Understanding Section 1031
The name Starker Loophole has been attached to the law since a 1979 court ruling concluded that an agreement to exchange property, within certain time limits, is essentially the same as a simultaneous transfer of property.
The loophole used to be much more generously defined. Prior to Dec. 31, 2017, like-kind property could be any of a broad range of real and tangible personal property held for business or investment purposes including franchises, art, equipment, stock in trade, securities, partnership interests, certificates of trust, and beneficial interests.
For 1031 exchanges concluded after Dec. 31, 2017, the only permissible property is business or investment real estate.
Rules for Using Section 1031
Section 1031 defers tax on swaps of like-kind real estate done in a timely manner. There are a number of important steps to a properly structured 1031 exchange:
- The real estate purchased with the proceeds must be like-kind.
- The tax must be paid on any “boot” in the year of the 1031 exchange. A boot is an addition of value to the swap that is not real estate.
- Once the business or investment real estate is sold, like-kind real estate must be identified within 45 days and acquired within 180 days.
About Like-Kind Real Estate
Section 1031 defines like-kind as real estate that is held for productive use in a trade or business or for investment purposes. Section 1031 defers tax when this real estate is exchanged in a properly structured 1031 exchange for like-kind real estate that continues to be held for productive use in a trade or business or for investment.
About the "Boot"
Section 1031 allows an investor to give or receive cash or other property that is not like-kind in addition to the like-kind real estate being exchanged. Such additions to the deal, when given or received in a 1031 exchange, is called “boot.”
To qualify, the investor must use the proceeds of the real estate sale for the new real estate investment within 180 days or the due date of the tax return.
The boot triggers taxable gains or losses in the year of the exchange. The taxable amount that is not deferred by Section 1031 is the amount of the boot.
The taxable amount that is deferred by Section 1031 is the capital gain or loss on the like-kind real estate exchanged.
Timing of the Exchange
Section 1031 gives a taxpayer who sells business or investment real estate 45 calendar days from the closing to identify up to three (and under certain circumstances four or more) like-kind replacement real estate properties.
The replacement must be acquired and the 1031 exchange completed by the earlier of 180 calendar days or the due date (with extensions) of the taxpayer’s return.
Reporting a 1031 Exchange
Even though the tax is deferred and no gain or loss is recognized, the 1031 exchange must be reported on Form 8824, Like-Kind Exchanges. The form's instructions explain how to report the details of the 1031 exchange.
The gain recognized from the boot is reported on Form 8949, Schedule D (Form 1040), or Form 4797, as applicable. If depreciation must be recaptured, then this recognized gain may have to be reported as ordinary income.
There is a high level of complexity involved in the 1031 exchange process, and mistakes can result in significant costs. With that in mind, there are advantages to working with a reputable, full-service 1031 exchange company. In general, these companies cost less than attorneys who charge by the hour, and contracting a firm that has an established track record with these transactions can ensure that your like-kind exchange fulfils the requirements of the tax code.