Generally speaking, when a property owner sells a piece of investment real estate they will pay tax on any increase in the appreciated value over the basis, or the original purchase price, of the real property. The amount of tax to be paid will depend upon if the property is held for less than one year (short term gain) or longer than one year (long term gain). Capital improvements and depreciation recapture also come into play on what the actual basis is in the property for tax purposes.
A strategy that land or property owners can employ to defer or lessen taxes on the sale of land or investment real estate is to do a like-kind exchange. Section 1031 of the Federal Internal Revenue Code (IRC) allows the investor in business or commercial real estate to trade, exchange, or invest funds or proceeds from a sale of investment property to other-or like-kind-property if it is done in accordance with regulations as set forth under §1031 IRC.
The theory is that the property owner should not pay tax on the increased value of the real estate or investment property if they are trading, exchanging, or reinvesting the proceeds in the same or “like-kind” property. Tax is eventually paid when the property is sold and the proceeds are cashed out-or invested in different investments, say stock, bonds, cash, life insurance, CDs, etc.
§1031 of IRC has been around for many years, since 1921, but has been aggressively used to defer or lessen taxes on appreciated investment real estate only in the last 15 years by property owners.
Tax-free 1031 exchanges are not exclusive to real estate property. Tax-free exchanges can apply to virtually any property, be it real, personal, automobiles, machinery, etc. The key is that you cannot exchange real property for personal property, i.e. you cannot exchange an appreciated piece of real estate for a classic Chevrolet Corvette. Tax-free exchanges are extremely useful when you have appreciated property and by and large real property texts to appreciate over time. If the property value has stayed the same or has gone down in value, the need for a 1031 exchange greatly diminishes as the tax implications on the sale will be minimal unless the property has been fully depreciated.
Finally, there are many regulations which govern like-kind or 1031 exchanges as set forth in the Federal IRC. For example, the proceeds from the sale must be made payable to a third party exchange agent and not the seller; the seller must identify the replacement property within 45 days after the initial sale is closed; and the replacement property must be purchased and closed within 180 days after the relinquished property has been sold. The investor who is considering a tax free exchange is cautioned to consult a tax and legal advisor as to the specifics of the exchange before the exchange occurs, so as not to trigger unnecessary taxes in the transaction.
Leave §1031 Alone
The House Ways and Means Committee and the Senate Finance Committee have taken measures to drastically reform, or altogether eliminate, the §1031 Like-Kind Exchange section of the IRS Code, which would have a significant negative impact on the value of real property.