If you are selling certain property and plan to reinvest the proceeds from the sale into similar, “like-kind” property, you won’t have to pay capital gains tax on the sale of your property. This is the basis for IRC Section 1031, also known as the 1031 exchange. Put simply, a properly structured 1031 exchange allows an investor to sell property, reinvest the proceeds into new property, and defer all capital gains taxes on the property being sold.
While many people are aware of Section 1031 exchange rules as they pertain to the sale of real estate, they are pleasantly surprised to learn that the rules extend to many other property types. Selling your private jet and buying another? Are you an art collector wishing to trade in your Degas for a Monet? Section 1031 exchange rules may very well apply to your sale.
Which Types of Property Qualify?
Both the property you are selling and the property you are buying must meet the criteria for what is called “qualifying property.” For a Section 1031 exchange, qualifying property is defined as property (or equipment) that is held for investment purpose or explicitly used in a taxpayer’s trade or business.
Qualifying property must also meet the definition of “like-kind” property which is property of the same nature, character, or class. Most real estate is like-kind to other real estate. However, Section 1031 can also apply to a host of non-real estate properties such as airplanes, vacation homes, or works of art. These will also need to meet the like-kind threshold, when exchanging one of these property types for another, to qualify for the capital gains tax exclusion. For purposes of section 1031, both real property (e.g., real estate holdings) and personal property (e.g., airplanes and artwork) can each qualify as exchange properties. However, Section 1031 does not allow real property to be like-kind to personal property.
For real estate assets, perhaps the most common type of property where Section 1031 could apply, there are a wide variety of interests that are considered like-kind to each other. These include:
- Fee interest and fractional (tenancy-in-common) interest
- Leasehold interest, 30-year plus lease
- Easements for conservation and right-of way
- Water and mineral rights
- Oil & Gas interests
- Transferrable development rights
“If properly structured, taxpayers can benefit substantially from Section 1031 tax deferred exchanges. The rules are complex and the property types that qualify are somewhat limited.”
While many different types of property that will benefit from the Section 1031 exchange rules, there are also many types that are specifically excluded. These include:
- A personal residence
- Land under development or property specifically purchased for resale
- Construction or fix/flips for resale
- Inventory or stock in trade
- Corporation common stock
- Partnership interests, certificates of trust, LLC membership interests
- Bonds and notes
The “Held For” Requirement
Regulations under Section 1031 do not specifically define what “held for investment” or “for productive use in a trade or business” mean in terms of qualifying for the capital gains tax deferral. The length of time a property must be “held for investment” is also not clearly spelled out.
We do know, however, that the following general rules apply in cases of “qualifying property”:
- The property must be used in a trade or business in which the taxpayer is engaged.
- While personal use property is not qualifying property, a minimal amount of personal use property will not disqualify property from being trade or investment property. Therefore, some personal use property may, indeed, be qualifying property.
- Mixed-use property has its own set of challenges and complexities. It will need to be scrutinized on a case by case basis to determine if it qualifies under Section 1031.
Give Boot “the Boot”
Any “boot” received (e.g., cash, debt relief, or the fair market value of any “other property” received by the taxpayer in an exchange of like-kind replacement property) is taxable. Depending on your business objectives, receiving this boot can be okay. However, if you want to structure your 1031 exchange to be completely tax free, you should avoid boot at all costs. To do this, always target replacement property of equal or greater value than the property you are selling.
If properly structured, taxpayers can benefit substantially from Section 1031 tax deferred exchanges. The rules are complex and the property types that qualify are somewhat limited. However, with a trusted tax advisor to guide you, Section 1031 can provide you with a significant tax savings benefit in deferring capital gains on the sale of your property.