What Is Section 1031?
Section 1031 is an Internal Revenue Code (IRC) provision that defers tax on qualifying exchanges of like-kind real estate. Section 1031 is also known as the Starker Loophole. Qualifying Section 1031 exchanges are called 1031 exchanges, like-kind exchanges, or Starker exchanges.
Section 1031 Explained
Section 1031 defers tax on properly structured 1031 exchanges. For 1031 exchanges concluded prior to December 31, 2017, like-kind property includes a broad range of real and tangible personal property held for business or investment such as franchises, art, equipment, stock in trade, securities, partnership interests, certificates of trust, and beneficial interests. For 1031 exchanges concluded after December 31, 2017, recently enacted tax legislation makes it clear that the only permissible property is a business or investment real estate. As a result of this change, this article focuses on 1031 exchanges of like-kind business and investment real estate concluded after December 31, 2017.
Section 1031 Real Estate
Section 1031 property, for 1031 exchanges concluded after December 31, 2017, is real estate held for investment or for productive use in a trade or business. The real estate must be located in the United Sates to be like-kind.
Section 1031 Steps to a Tax-Deferred Exchange
Section 1031 defers tax on swaps of like-kind real estate done in a timely manner. The most important steps to a properly structured 1031 exchange are:
- Replacement real estate must be like-kind.
- Tax must be paid on any “boot” in the year of the 1031 Exchange.
- Once business or investment real estate is sold, replacement like-kind real estate must be identified within 45 days and acquired within 180 days.
Like-Kind Real Estate Defined
Section 1031 defines like-kind as real estate that is held for productive use in a trade or business or for investment. 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.
Section 1031 allows an investor to give or receive cash, liabilities, or other property that is not like-kind in addition to the like-kind real estate exchanged. Cash, liabilities or other property that is not like-kind and that is given or received in a 1031 exchange is called “boot.” 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.
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 the 1031 Exchange
Even though tax is deferred and no gain or loss is recognize, the 1031 exchange must be reported on Form 8824, Like-Kind Exchanges. Form 8824's instructions explain how to report the details of the 1031 exchange. Gain recognized because boot was received 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.