Under Section 1031 of the Internal Revenue Code (26 U.S.C.), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.
To qualify for Section 1031 of the Internal Revenue Code, the properties exchanged must be held for productive use in a trade or business or for investment. Stocks, bonds, and other properties are listed as expressly excluded by Section 1031 of the Internal Revenue Code. The properties exchanged must be “like-kind”, i.e. of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. Personal property used predominantly in the United States and personal property used predominantly elsewhere are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Taxpayers may wonder whether items such as equipment used on a property are included in the lump-sum sale of the property, and if they are able to be deferred. Under treasury regulation §1.1031(k)-1(c)(5)(i), property that is transferred together with the larger item of value will not exceed 15% of the fair market value of the larger property. So for equipment with a fair market value of $15,000, as long as the qualified like-kind property sells for >$100,000, the equipment can be included in the exchange of property and any gain realized can be deferred.
Cash to equalize a transaction cannot be deferred under Code Section 1031 because it is not like-kind. This cash is called “boot” and is taxed at a normal capital gains rate.
If liabilities assumed by the buyer exceed those of the seller (taxpayer), the realized gain of the seller will be not only realized, but recognized as well. If however, the seller assumes a greater liability than the buyer the realized loss cannot offset any realized and recognized gain of receiving boot such as cash or other personal property considered boot.
Originally, 1031 cases needed to be simultaneous transfers of ownership. But since Starker vs. U.S. (602 F.2d 1341), a contract to exchange properties in the future is practically the same as a simultaneous transfer. It is under this case that the rules for election of a delayed 1031 originated. To elect the 1031 recognition, a taxpayer must identify the property for exchange before closing, identify the replace property within 45 days of closing, and acquire the replacement property within 180 days of closing. A Qualified Intermediary must also be used to facilitate the transaction.