Section 1031 Exchange defined

A 1031 Exchange, also sometimes called a Like Kind Exchange or a Starker Exchange, is a way of structuring the sale of property so that the seller’s taxable profit or gain is deferred. If the property that is sold is replaced with another “like kind” property and if the transaction is properly structured, the seller’s profit or gain may be deferred out to the date the replacement property is sold (or perhaps longer if the replacement property is subsequently exchanged).

The logic behind a 1031 Exchange is that since the taxpayer is simply exchanging property for another "like kind" property, thetaxpayer has received nothing to pay taxes. All gain is in still being held in the form of property, so no gain or loss should be recognized or for income tax purposes.

Let's take a look at the actual section of the code where this benefit originates for a definition of what this means. Section 1031 of the Internal Revenue Code:

"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."

It is a common misunderstanding that the relinquished property sale, and the replacement property acquisition have to be simultaneous. However, the majority of exchanges that have occurred over the past twenty five years are not simultaneous. This was the result of the 1984 Starker tax court case (and, hence, the name Starker Exchange). In 1991, the IRS issued the present day section 1031 rules.

For a non-simultaneous exchange, the taxpayer must use a Qualified Intermediary (also sometimes ccalled an Exchange Accommodator or Facilitator), follow IRS guidelines, and use the proceeds of the sale to buy qualifying, like-kind, investment or business property. The IRS rules require specific time clocks to be followed. The replacement property must be “identified” within 45 days after the sale of the old property and the acquisition of the replacement property must be completed within 180 days of the sale of the old property.

Section 1031 is most often used in connection with the sale of real property. For real property exchanges under Section 1031, any property that is considered "real property" under the law of the state where the property is located will be considered "like-kind" so long as both the old and the new property are held by the owner for investment, or for active use in a trade or business, or for the production of income.

Some exchanges of personal property can qualify under Section 1031, however, the classifications of what is "like kind" become a lot more specific and limiting. Shares of corporate stock in different companies will not qualify. Exchanges of partnership interests in different partnerships and exchanges of livestock of different sexes do not qualify.

In order to obtain full benefit, the replacement property must be of equal or greater value and all of the proceeds from the relinquished property must be used to acquire the replacement property. The taxpayer cannot receive the sales proceeds of the old property. Exchanges are typically structured so that the taxpayer's interest in the relinquished property is assigned to a Qualified Intermediary prior to the close of the sale. That way, the taxpayer does not have access to or control over the funds when the sale of the old property closes.

At the time the relinquished property is sold, the proceeds are sent directly to the Qualified Intermediary. The proceeds from the sale of the relinquished property are deposited by the QI and held until the purchase the replacement property. After the acquisition of the replacement property closes, the QI delivers the property to the taxpayer and the exchange is complete.