by Bradley Streeter

Created on: August 11, 2008   Last Updated: August 19, 2008

For investors looking to sell assets in order to buy others, Section 1031 of the Internal Revenue Code might provide an opportunity to avoid federal income tax on capital gains that would otherwise be due on the sale. A 1031 exchange, or "like-kind exchange", is a series of transactions by which an investor or business owner essentially trades one asset for another, the realized gain reflected in the basis of the new property rather than on the year's tax bill.

Although primarily encountered in real estate transactions, many types of business or investment assets may be involved in a 1031 exchange. The biggest exception is that the sale and repurchase of partnership interests, stocks, bonds and other securities does not qualify for 1031 treatment. The two main requirements of a like-kind exchange are that the property sold and bought actually be "like-kind" and that they are held for productive use or investment. The like-kind requirement simply means that the exchanged properties must be of the same class; real estate for real estate, vehicle for vehicle, et cetera. The requirement that the property be held for productive use or investment means that neither the property disposed of nor the property acquired was for personal use.

Like-kind exchanges do not have to be simultaneous and can involve multiple parties. For a delayed 1031 exchange, the seller must identify the replacement property within 45 days and must acquire the replacement within 180 days of disposing of the for-sale asset. The taxpayer is required to retain a "qualified intermediary" in order to take advantage of a delayed 1031 exchange.

The value of a 1031 exchange is apparent for those "trading up" from one appreciating asset to another. Yet, this strategy is also useful when "trading down", when changing types of real estate, and when replacing depreciating assets. By way of example, here are three hypothetical situations to illustrate these lesser-known ways to take advantage of Section 1031.

A taxpayer buys an investment property for $100,000. Several years later, the taxpayer wants to downsize to free up cash. The taxpayer sells the property for $200,000, buying a new investment property for $150,000. Although there will be capital gains tax due on the sale, it is due on $50,000 rather than the full $100,000 of realized appreciation.

A taxpayer wanting to get out of real estate can change markets without taking a capital gains tax hit. Since the IRS treats all investment real estate in the United States as like-kind, the taxpayer can sell three rental houses to another landlord in order to buy a medical office building, and have the transactions treated as a like-kind exchange.

A taxpayer wishes to buy a new business computer system for $5,000. The taxpayer has an old system, with a basis of $1,000, but is able to sell the old system for $2,000. The taxpayer makes the sale, immediately purchasing the new computer system. The taxpayer is able to avoid capital gains tax on the sale of the old computer for more than his basis.

Structuring a transaction as a 1031 exchange can be a valuable business strategy, whether dealing with real estate or other type of asset. Any investor or business owner wishing to "trade in", whether up or down, should consult with a tax attorney or accountant to determine whether they can structure the deals so that they are ignored for income tax purposes.

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