How to Define a 1031 Exchange
A 1031 exchange refers to Section 1031 of the Internal Revenue Code. If a business uses this exchange, it can trade one property for another property, and the business does not have to report a gain or a loss for this year on its federal income tax return. Some states also exempt the business from state income taxes when the business performs a 1031 exchange.
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Like Kind
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The 1031 exchange is known as a like kind exchange. The business must trade a property for another property that is of like kind. Like kind refers to the purpose that the business intends to use the property for. The property does not have to have the same value as the other property, and does not have to be maintained in the same condition. The business can trade a parcel of land with a house on it for a parcel of unimproved land and still qualify for a 1031 exchange.
Tax Benefits
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A 1031 exchange is a temporary deferral of income taxes. The business will still have to report a gain or loss if it sells the property that it receives in exchange for its other property. If the business sells this property, it can use the tax basis of the original property to set the value it uses when it calculates whether it earns a gain or a loss on the sale. According to the Internal Revenue Service, adjustments apply to this original basis, so the new tax basis won't have exactly the same value as the tax basis of the original property.
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Qualifying Properties
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The purpose of the 1031 exchange rule is to allow a business to trade properties that would be inconvenient and costly to appraise. Most 1031 exchanges involve a real estate trade. According to the Internal Revenue Service, a business can also trade livestock in a like kind exchange, but a cow is not considered like kind to a bull, and any other male and female animal are not like kind to one another. The business cannot use a 1031 exchange to trade stocks, bonds, or other securities.
Cash
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In some real estate transactions, the business exchanges a parcel of real estate for another parcel of real estate plus additional cash, known as the boot. According to the Internal Revenue Service, if one trader provides cash as part of the trade, this cash exchange must take place after the trade is final for the trade to qualify for a 1031 exemption.
Time Frame
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Time limits apply to a 1031 exchange. According to the Internal Revenue Service, once the trader decides to sell the original property, the trader then has 45 days to select the other properties that are acceptable for an exchange. A second time limit applies to the receipt of the other property. The trader must take possession of the other property either by 180 days after the sale, or the date that the trader would have to pay federal income taxes on the sale of the original property, if it is earlier.
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