A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, is a transaction in which eligible property is exchanged for property of "like-kind," and any gain or loss is deferred for federal income tax purposes. Typically, when a taxpayer sells a property, any gain or loss on the sale is recognized in the tax year in which the sale occurs. However, in a like-kind exchange, any gain or loss on the sale of the relinquished property is deferred until the replacement property is sold.
The fundamental principle here is that the transaction is considered an exchange rather than a standard sale, allowing the taxpayer to postpone capital gains taxes that would typically arise from selling an asset. A transaction meets the criteria for a 1031 exchange when it involves the exchange of eligible like-kind properties. It's important to note that, following the Tax Cuts and Jobs Act (TCJA), only real property qualifies for a 1031 exchange.
What types of property do not qualify for a 1031 exchange?
- A property sold for cash, including transactions where the sale proceeds are reinvested in like-kind property. In order to qualify as a 1031 exchange, the sale and purchase must be steps in an integrated plan, not independent transactions.
- Property such as inventory, which is held primarily for sale.
- Property that serves as a taxpayer’s primary residence and other property held for personal use.
- Stock, bonds, notes, other securities, or evidence of indebtedness or interest.
- Interests in a partnership, except a publicly traded partnership.
- Certificates of trust, certificates of beneficial interests, and choses in action.
What type of real property qualifies for a 1031 exchange?
For a real property to qualify for a 1031 exchange, it must be considered real property according to the laws of the state or local jurisdiction where the property is located at the time of the exchange. Additionally, the taxpayer must hold the properties being exchanged for an eligible purpose to qualify for a 1031 exchange.
Examples of eligible purposes include:
- The 1031 exchange property must be held for productive use in a trade, business, or investment.
- Land — and improvements to the land — is a property that qualifies for a 1031 exchange. The term “improvements to land” means inherently permanent structures like buildings and the structural components of inherently permanent structures such as walls, floors, and ceilings.
- Water and the air space over it — “superjacent” — are eligible for a 1031 exchange. An example would be boat slips at a marina.
- Unsevered natural products of land can also qualify for a 1031 exchange. Unsevered natural products of land include things like growing crops and timber, mines, wells, and other natural deposits. Natural products like crops, timber, water, ores, and minerals will no longer qualify for a 1031 exchange once they’re severed or removed from the land.
Do intangible interests qualify for a 1031 exchange?
Intangible interests such as fee ownership, co-ownership, leasehold, option to acquire real property, easement, stock in a cooperative housing corporation, and shares in a mutual ditch, reservoir, or irrigation company qualify for a 1031 exchange if they are considered real property under Section 1031.
What if a 1031 exchange includes like-kind property and boot?
If a 1031 exchange involves both like-kind property and "boot," there may still be a partial deferral of gain. "Boot" refers to any cash or non-like-kind property received during the exchange. In such cases, the taxpayer will recognize a gain up to the fair market value of the boot. However, any loss in the transaction will still be deferred, even if the boot is involved.
Are 1031 exchanges permitted in all states?
All states permit 1031 exchanges, with most following federal income tax guidelines for like-kind exchanges. Certain states, like California, Oregon, Montana, and Massachusetts, have specific "claw-back provision" regulations.
These rules mandate that any appreciation in property value within the state is subject to state taxes, irrespective of whether the property was exchanged in a different state. California, in particular, has unique reporting regulations for like-kind exchanges, while many states impose real property transfer taxes on such transactions.
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