Are you looking to invest in some new business property, but you have no cash? If you currently own some business property that you don’t mind parting with, then a 1031 exchange may be just the thing for you. Under the Internal Revenue Code Section 1031, taxpayers can exchange like-kind properties without the gain or loss being recognized by the IRS until the property is sold through a taxable transaction.
What that means is, if you own an apartment building, you could exchange it for a body shop, and the IRS would defer (not remove) the taxes on the gain from the exchange until you actually sell the shop. If the exchange resulted in a loss, the amount of the loss could not be deducted on your tax return. Not all properties exchanged are non-taxable or tax-deferred.
If properties of an unlike-kind is added the exchange, such as cash, the IRS will recognize that gain as being taxable. Properties must (1) qualify, and (2) be of like-kind. Here is a description of what constitutes as qualified and like-kind property:
Qualifying property Both properties in the exchange must be of a business nature. It can be either real or personal property as long as it is for business and is currently productive. A burned down convenient store would not qualify, but a convenient store that is currently running would.
No property for personal use can qualify. Your home would not qualify under Section 1031, since it’s a personal use property unless it had been exchanged with a rental home and served as business property for at least 5 years before making it your primary residence. Any property held for the purpose of being sold, like the real estate inventory from real estate dealers, is disqualified as well.
Once the property is exchanged, it must be identified 45 days after the transfer and must be delivered either180 days after the transfer or by the due date of the receiver’s tax return for that year, whichever comes first. Failure to comply with any of these rules would result in the exchange becoming taxable. Cash, stocks, and bonds do not qualify under section 1031, but stocks and bonds can be traded tax-deferrable under another section.
Properties owned within a partnership, generally, do not qualify for a tax-deferred exchange, but a business property exchanged by a partnership with another business property from another party can qualify as long as the two are of like-kind.
Like-kind property -To be tax-deferrable under section 1031, properties must be of “like-kind” but they don’t have to be of “like-quality”. Exchanging real property for real property is considered like-kind, even if one is of greater value than the other. Exchanging personal property (like a commercial truck) for real property (like an apartment building) would not be considered like property. Livestock that are of two different sexes are not considered like-kind. If one real property is in the U.S., but one is outside the U.S. they cannot be considered of like property. Also, personal business property that is mostly used within the U.S. borders is not considered of like-kind with personal business property mostly used in another country.
Like-kind exchanges can be very complicated and they bring the most benefit only when the rules of the code are followed explicitly. It’s best to consult a tax professional before attempting any property exchanges. For more information, please go to http://www.irs.gov/pub/irs-pdf/p17.pdf