Section 1031 Exchanges

A 1031 Exchange is a legal way to defer your tax obligation on an investment property. This tax code is most commonly used in real estate transactions and may also be a delayed exchange or an exchange to delay capital gains taxes. The real estate attorneys at The Law Offices of Diron Rutty, LLC can help explain.

In a typical transaction, the property owner is taxed on any gain from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date (usually when the property is again sold).

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind,” while deferring the payment of federal income taxes and some state taxes on the transaction.

Real Estate Investors Can Take Advantage of the System For Their Investment Property

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has yet to be realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.