Tax Information: What Is Irs Section 1031?

IRS Code Section 1031 allows an individual to defer capital gains on the sale of a property by quickly purchasing another property.

Section 1031 of the Internal Revenue Service Code is commonly referred to as the "like kind exchange" provision. This provision allows the owner of a depreciated asset to use the money gained from the sale of the asset to purchase another asset of greater value within a specific time period and thereby defer capital gains taxes.

Investment assets, like commercial properties, depreciate in value each year. Each property can be depreciated over a period of 27.5 years. This allows the owner of the asset to claim a certain percentage of its value as a loss against his tax return each year. For example, a property is purchased for $100,000. The purchaser has a $100,000 cost basis in the property. The owner of the property can depreciate the cost basis of the property at a rate of $3636.63 during each year of ownership, up to a maximum of 27.5 years. This depreciation value is subtracted from the income or profit of the owner's tax return. If the owner of the property holds the property for 10 years, he depreciates the property $36,363. This reduces his cost basis in the property to $63,637. If the owner sells the property for $120,000 at the 10 year mark, he will be required to pay capital gains taxes of 20% on the difference in the sale price and the cost basis. The owner would therefore owe taxes on $56,363.

Section 1031 allows the seller of a depreciated asset to purchase another property of a like kind within a certain time and defer taxes on the capital gain associated with the sale of the first property. This would allow the purchaser of a $100,000 property to depreciate the property $36,363 over 10 years, then sell the property for $120,000 for a capital gain of $56,363, use the $56,363 to purchase a property priced more than $120,000, and avoid any taxes on the capital gain. The owner would otherwise have to pay taxes on $56,363 at a rate of 20%, so the process allows him to save $11,272 on the sale of the first property.

The IRS has several regulations concerning like kind property exchanges. The first requirement is that the owner may not receive any cash profit from the sale of the first property. The proceeds from the sale ($56,363 in the previous example) are placed in a type of trust account with a qualified intermediary. A qualified intermediary is an independent third party who holds the profits in a trust account until the seller finds a new property to purchase. The seller cannot physically receive any of the profits or he will be required to pay capital gains taxes.

The IRS also places stringent time limitations on the period in which to make the second purchase. The seller has 45 days from the sale of the first property to locate another property to purchase. This location is typically complete when the seller delivers a purchase offer contract to the owner of the identified property. If the original seller does not deliver a contract to purchase a new property within 45 days, the funds are released from the qualified intermediary, and the seller must pay taxes.

The purchase of the like kind property must also be closed within 180 days of the sale of the original property. If the seller fails to close on the like kind property within 180 days of the sale of the original property, he forfeits the exemption and must pay taxes on the capital gains.

Section 1031 applies only to investment properties and assets, and cannot be used when selling your personal residence. The seller who utilizes Section 1031 also should exercise caution when identifying a similar property to purchase. If the seller identifies a property within 45 days and is set to close on the 175th day, he may be faced with a dilemma if the property is destroyed by fire on the 173rd day. The seller would then be forced to locate a new property and close a purchase of the property in one week. Therefore, it may often be advantageous for the seller to identify several potential properties before the 45 day time limit.

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