What is a 1031 Exchange?

You might have heard of the term 1031 exchange, especially if you own real estate. It’s a section of the Internal Revenue Service (IRS) Code that provides a mechanism to defer capital gains tax under certain circumstances. Here is some basic information about the 1031 exchange, and how the rule came into being:

DEFINITION of ‘Section 1031’

A section of the U.S. Internal Revenue Service Code that allows investors to defer capital gains taxes on the exchange of “like-kind” properties for business or investment purposes. Taxes on capital gains are not charged on the sale of real property if the money is being used to purchase another property – the payment of tax is deferred until the property is sold with no re-investment.

UNDERSTANDING ‘Section 1031’

The idea behind this section of the tax code is that when an individual or a business sells a property to buy another for business or investment purposes, no economic gain has been achieved. There has simply been a transfer from one property to another.

In the past, this rule could be used for like-kind exchanges of many kinds of tangible property, including artworks, franchises and heavy equipment. However, since the new tax legislation of Dec. 2017, like-kind exchanges are only permitted for real-estate properties. For example, if a real estate investor sells a building to buy another one, he or she will not be charged tax on any gains he or she made on the original building. This is because no gain in value has been realized, rather, the original value is simply being stored someplace else.