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IRS Section 1031

IRS Section 1031 allows taxpayers to defer paying capital gains taxes when they exchange one business or investment property for another that is of "like-kind." Here's how it generally works:

  • Identification Period: After selling a property, the taxpayer has 45 days to identify in writing to the IRS potential replacement properties.
  • Exchange Period: Once identified, the taxpayer has 180 days to acquire one or more of the replacement properties.
  • No Gain Recognition: If the exchange meets the IRS criteria for a like-kind exchange, the taxpayer does not have to recognize any capital gains from the sale of the relinquished property at the time of the exchange.

The Alleged "Loophole"

Critics of Section 1031 argue that the provision can be exploited by taxpayers to indefinitely defer paying capital gains taxes. They point to situations where investors continuously roll over their gains into new properties through a series of like-kind exchanges, essentially deferring taxes until they eventually sell a property outside of a 1031 exchange.

While this strategy may seem like a "loophole", Section 1031 has built-in limitations and complexities that make it less straightforward than it may appear.

  • Recapture of Deferred Taxes: If the taxpayer sells a property outside of a 1031 exchange, the deferred capital gains taxes come due. This is known as "recapture" and it can be significant.
  • Strict Like-Kind Rules: The properties involved in the exchange must be "like-kind", which means they must be of the same nature or character, even if they differ in quality or grade. This limits the types of property that qualify for the exchange.
  • Boot and Partial Exchanges: If the taxpayer receives "boot" (non-like-kind property, cash, or other assets) as part of the exchange, it may trigger immediate capital gains tax liability on the boot received.
  • Complex Rules and Timelines: Complying with the IRS's stringent rules and deadlines for 1031 exchanges can be challenging, and any deviation can result in tax consequences.

The Intent of Section 1031

Section 1031 serves a specific purpose: to encourage investment in real estate and other productive assets by allowing taxpayers to reinvest their gains. This, in turn, can stimulate economic growth and job creation.

Tax deferral is not the same as tax avoidance. Eventually, these taxes will come due when the property is sold outside of a 1031 exchange or as part of an estate.

Section 1031 is more complex than it seems and comes with built-in limitations and requirements. While it may offer tax deferral benefits, it does not provide a way to entirely avoid paying taxes on capital gains.

Schell & Hogan, LLP Can Help

Taxpayers interested in utilizing Section 1031 can consult with Schell & Hogan to navigate its intricate rules and ensure compliance with IRS regulations. Give us a call and let us know how we may be of assistance.