Many of us cringe at the thought of such numbers as 1040 and 1099. Numbers like these usually bring about visions of last minute tax preparation and hard-earned money being flushed down the figurative toilet. In the case of the number 1031, it refers to a portion of the Internal Revenue Code as well. It should not however, incite terror in the minds of those who come across it. For those of us who have a piece of investment property, section 1031 and its provisions are a great way to trade up without having to pay Uncle Sam at each step. We are dealing with the IRS so there are, of course, numerous guidelines to follow along the way to make sure you aren’t just trying to shirk the government. After all, they have to make a living too.
Section 1031 addresses Like Kind Exchanges. These are exchanges of similar property between two or more parties. When the property is exchanged, the parties are allowed to defer any tax associated with the sale until the new property is sold. In some instances it is possible to continually defer the tax as you trade up from property to property. One of Benjamin Franklin’s famous quotes puts it best. “In this world nothing can be said to be certain, except death and taxes.” In the instance of continual tax deferrals, both of these certainties will be realized at the same time.
There are numerous types of property classes that would constitute like kind exchanges, but the one we will focus on and the one that is most relevant to us is real estate. Considering the volatility of the stock market, real estate is often a sound approach to investment diversification. For the most part, tax code considers any real estate, whether improved or unimproved, to be of like kind. Simply put, a half-acre, undeveloped home site in a subdivision is treated no differently than a cottage on Lake Chemung or a commercial space on Grand River. Regardless of what the property is, its purpose is clearly stated. The property must be held for investment or be used productively for a business. It would not be possible to defer the tax exchange your primary residence of the past five years for a new home.
When this section of the Internal Revenue Code was written, it was most likely intended to alleviate some of the work involved with tracking numerous livestock trades around the country. Farmers were frequently trading horse for horse and cow for cow and the paperwork was a nightmare. Today, a livestock provision is still included in the code prohibiting the trade of livestock of different sexes. What, I can’t trade my prize bull for those two beautiful Guernsey’s?
Ok, so the average person these days isn’t going to be trading any livestock. It is entirely possible that you are ready to upgrade that beach condo to the beach house down the street however. The basic idea behind the 1031 was and is to allow taxpayers to continue an investment with out continually being taxed on the gains as your investment(s) improves. Since economic gain may only be reflected on paper and not realized in a way that makes funds available to pay the tax, you are able to defer the payment until a future sale.
Consider this example:
Five years ago, Jerry found a steal on a beach condo in Del Boca Vista. He paid $200,000 for the 2 bedroom, 2 bath unit. Three years ago, he sold the condo for $250,000 and felt comfortable with the purchase of another condo down the street for $300,000. Now, three years later, he is about to close on the sale of your condo for $400,000. At the same time, Jerry is considering a beach house in another part of the city for $500,000. Between the sales of both condos, you would have $150,000 in taxable income earned from gains on each sale. This would amount to tens of thousands in tax to be paid in the year of each sale respectively. If these sales and purchases had been like kind exchanges, which they easily could have been, Jerry could have deferred all the tax until the sale of the newest property. If that investment were exchanged for another, or even for several, then the tax deferment would continue.
Some of you might be wondering how you could possibly find someone in such a limited amount of time with whom to exchange property. Amongst the jargon in section 1031 provisions are provided, allotting specific amounts of time to locate and purchase your new investment. As long as you fall into those time frames, you can utilize the 1031. Ultimately, Ben Franklin’s quote will hold up and you will have to pay up. If you have deferred tax for the past 20 years, you will have to pay it eventually.
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