What is a 1031 Deferred Exchange?

Few people who’ve paid capital gains tax on the sale of property have been thrilled with the prospect. Many wish there was some way to avoid paying them. In fact, there is a way to avoid paying capital gains tax in certain situations —- at least for a time. One way is called the 1031 deferred exchange, which is also referred to as a 1031 like-kind exchange, a situation discussed in the Internal Revenue Code that allows for deferring taxes until a later date.

A person can take advantage of a 1031 deferred exchange by selling a piece of property, whether real or personal, and acquiring a piece of similar property. Under certain conditions, the taxpayer would not have to pay taxes on the sale of the first property until the initial property is sold or otherwise disposed of. This could mean deferring taxes for years.

One of the most important qualifiers for a 1031 deferred exchange is the type of property involved; the property has to be intended for business, trade, or investment use. Consider a home, for example. If a person does an exchange involving homes he acquired for investment purposes, they may qualify for a 1031 deferred exchange. However, the same would not hold true for homes he has for personal use, such as residences and vacation homes. Additionally, real estate that is owned outside of the United States does not qualify, even if the owner pays United States taxes.

The term like kind can be difficult to figure out, at least the first time a person hears about 1031 exchanges. One of the most important things to consider is that the property only has to be alike in nature; it doesn’t have to be exactly the same. For example, a person could exchange an office building for a condominium property. However, he could not exchange a car for a house. Interestingly, livestock is not treated as like-kind property if the animals are not the same sex, even if they are the same type of animal.

There are five different types of 1031 deferred exchanges, and each one has its own set of requirements and deadlines. Since the Internal Revenue Code Section 1031 governs these exchanges, it can be helpful to read IRS literature about these exchanges before attempting them. Some people also seek the help of 1031 deferred exchange attorneys in understanding the laws and avoiding common pitfalls as well as planning for the best possible timing.