What
is a 1031 Exchange?
Section
1031 is the provision of the Federal Income Tax Code that
permits companies and individuals to exchange property of a
like-kind without incurring any liability for paying capital
gains tax dues.
Idea
behind 1031 Exchange
An
exchange does not generate cash. Therefore, it is unfair on
the taxpayer to ask him or her to pay tax on unrealized gain
or “paper” gain. The taxpayer’s investment is
essentially the same, only the form changes. For example,
exchange of land for building.
Effectively
the taxpayer is deferring his or her tax liability. When the
replacement asset is eventually sold for cash, the gain
realized is subject to tax.
Section
1031(a) 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 if such property is
exchanged solely for property of like-kind which is to be
held either for productive use in a trade or business or for
investment”. Like-kind refers to the nature of the
property and not to the quality of the property. Two
dissimilar real properties can be exchanged.
In
a like-kind exchange both the property transferred and the
property received must be held either:
a)
for productive use in the trade or the business
b)
for investment
Example
:- Jack owns land used in his business. He exchanges the
land for another land which is to be held for investment. No
gain or loss is recognized by Jack because he has exchanged
property used in a business for a like-kind property to be
held for investment.
Example
:- Annie’s automobile is held for personal purposes only.
She exchanges it for stocks with a fair market value of
$10,000. The automobile was purchased for $7,000. A $3,000
gain is recognized because the automobile is not used in a
trade for business or held for investment. The exchange is
not a like-kind exchange because both personal use assets
and stock do not qualify as like-kind property.
If
the exchange qualifies as a like-kind exchange
non-recognition of gain or loss is mandatory. Therefore, if
a taxpayer prefers to recognize a loss on an exchange so
that his overall tax dues reduces, he or she must structure
the transaction in such a way that it does not qualify as a
like-kind exchange. This can be done by selling the old
property in one transaction and buying the new property in a
separate, unrelated transaction.
Example:-
John sells a truck used in his business to Cathie for a
loss. After the sale, John purchases a truck from Chris. The
loss is recognized because these two transactions do not
qualify as an exchange of like-kind property as the
transactions are not interdependent.
A
nontaxable exchange exists when the taxpayer sells property
to a person and then purchases like-kind property from the
same person.
Example:-
John sells a truck used in his business to Chris for a loss.
After the sale, John purchases another truck from Chris. The
loss cannot be recognized because these two transactions
qualify as an exchange of like-kind property as the
transactions are interdependent.
Taxpayers
who want to exchange property do not always own property of
equal value. So to complete the exchange, non like-kind
property or money may be given. Such non like-kind property
or cash is referred to as boot. Gain is recognized to the
extent boot is received. However, the amount of recognized
gain is limited to the extent of the taxpayers realized
gain.
Example
:- Peter exchanges business equipment worth $70,000 for
$15,000 cash and business equipment with a fair market value
of $80,000. So the realized gain is
$25,000(80,000+15,000-70,000). Since the $15,000 boot
received is less than the $25,000 realized gain, the
recognized gain is $15,000.
Example
:- Peter exchanges business equipment worth $70,000 for
$15,000 cash and business equipment with a fair market value
of $65,000. So the realized gain is
$10,000(65,000+15,000-70,000). Since the $15,000 boot
received is more than the $10,000 realized gain, the
recognized gain is $15,000.
The
section does not apply to any exchange of:
1)
Inventory held for sale
2)
Stocks, bonds, or notes
3)
Other securities or evidences of indebtedness or
interest
4)
Interest in a partnership
5)
Certificate of trust or beneficial interests
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