A 1031 like-kind exchange can mean big tax savings for those who know how it works. The name refers to the section of the Internal Revenue Code that guides the process. The Internal Revenue Service (IRS) uses Section 1031 to recognize a gain or loss in a real estate transaction. When used wisely, this exchange can remove the tax burden that comes with selling certain properties.
What tax burden?
Those who sell investment property are generally responsible for two taxes: capital gains and depreciation recapture.
The IRS may expect a capital gains tax if an investment property owner is able to sell a property at a profit. For example, those who purchased a property for $500,000 and then sell it for $600,000 would likely have to pay capital gains tax on the $100,000 gain. The rate varies depending on how long the property owner owned the property prior to the sale.
The IRS will also expect the property owner to list depreciation deductions as taxable income once the property is sold. This will likely lead to a bigger tax bill.
What qualifies as a “like-kind” property?
The IRS defines “like-kind” property as those that are of the “same nature or character, even if they differ in grade or quality.” One apartment building for another will generally meet this definition, but property within the United States exchanged for property in another country generally does not. The agency also generally does not allow selling an office property in exchange for a vacation home.
It is also possible to do a partial 1031 exchange. Navigating the rules for a full or partial like-kind exchange can be complex. Is generally wise to have an attorney experienced in this niche area of real estate and tax law to help draft the documents to better ensure it meets the IRS’ requirements to qualify.