Section 1031 is a part of the Unites States Internal Revenue Service (IRS) Code that allows for those who exchange certain types of property to defer any taxes on the capital gains from the exchange. This law is mostly utilized for real estate transactions, but it can be used for any exchange of like-kind property. Since there is no realized economic gain in such an exchange, then there is no immediate tax to be paid on any capital gains, which are said to be unrealized gains. Taxes must eventually be paid if the property acquired in the exchange is subsequently sold.
In a normal sale of property, the individual who sells would be required to pay taxes on the money received for the property. With an exchange of like-kind property, Section 1031 stipulates that any capital gains or losses shall be unrecognized. Since there is simply a transfer of property from one person or entity to another, any gain is said to be just a paper gain, with no money changing hands. As such, the taxes on any possible gains may be deferred.
Real estate transactions are the most common types of Section 1031 exchanges. Such real estate must be held by the parties involved for trade, business, or investment purposes. This means that someone's personal residence is not eligible to be included in such a transaction. Many real estate transactions are multi-asset transactions, meaning that there is real and personal property traded between the parties, which must be discussed with IRS regulators to make sure that Section 1031 rules apply.
With personal property, much stricter rules apply in terms of whether it can be considered like-kind. The property must be considered of the same nature as that with which it will be traded, even if it is of lesser or greater quality. Property used within the U.S. that is exchanged with property used outside the U.S. does not qualify for the Section 1031 tax deferment. Exchanges of stocks, bonds, partnership interests, securities, or evidence of indebtedness are all subject to immediate taxation.
It is important to note that Section 1031 allows for taxes to be deferred, but such exchanges are not tax-free. If a property in a like-kind transaction is eventually sold, then the money gained in the sake is taxable, as are whatever gains were made in the like-kind exchanges that preceded the sale. In the case of multi-asset exchanges, there is the possibility that some of the gains made in the exchange will be tax-deferred as stipulated by Section 1031, while other gains, which involve property not considered like-kind, are deemed immediately taxable.