In general, you will owe tax on gains from the sale of property used in a trade or business. The same is true for gains arising from the sale of property held for investment. However, the tax code (Section 1031) provides an exception to this rule when proceeds from a sale are reinvested in similar property (i.e., property of a like-kind) as part of a qualifying like-kind exchange.
Important Note: This exception to the general rule ultimately allows you to defer paying tax on the sale of property, a concept known as a tax-deferred gain (as opposed to a tax-free gain). The significance of this difference arises when the like-kind property received is later sold/exchanged for property not considered to be like-kind (for example, cash, promissory note, etc.). At this point, any gain from the sale is taxable.
Qualifying Like-Kind Exchange
To qualify as a like-kind exchange, the property given-up and the property received must be both of the following:
- Qualifying property. This means that both the property given-up and the property received are used in your business or held for investment purposes.
- Like-Kind property. Meaning the properties are the same nature, character or class (even if they differ in grade or quality). Examples include land for land, residential real estate for residential real estate, or a truck for a truck.
Common Types of Exchanges
Two common types of exchanges are (1) a deferred exchange and (2) a simultaneous exchange.
In the case of real estate, the property (properties) subject to the deferred gain arising from 1031 exchanges is often placed into the possession of an intermediary for a prescribed 60-90 day period. During this period, the taxpayer has an opportunity to “reinvest” proceeds from an asset sale into property considered “like-kind” (loosely defined as property of the same nature, character or class). This type of transaction is a deferred exchange, and it is generally accompanied by contractual obligations for all parties involved.
On the other hand, a simultaneous exchange is one in which property is swapped at the same time. A common example of this type is the trade-in of one vehicle (i.e., Ford F-150) for the newer model of that same vehicle (Ford F-150).
Specifically Omitted Items – Section 1031 Exchanges
Be aware that the following types of property are specifically excluded from Section 1031 treatment:
- Personal Use property (i.e., primary residence or vacation home),
- Financial Securities (i.e., stocks, bonds, or notes), and
- Partnership Interests
Lastly, it is important to understand that while real property (i.e., land or buildings) and personal property (i.e., equipment, vehicles, etc.) can both qualify for like-kind exchanges, neither can qualify for this treatment in exchange for the other.