What is a 1031 tax-deferred exchange?
In a Section 1031 Exchange, the tax on the gain is deferred until some future date, whereas in a typical transaction, the property owner would be taxed on any gain realized from the sale. Section 1031 of the Internal Revenue Service Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. In a tax-deferred exchange, a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.
The premise of a 1031 Exchange is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed. Consequently, it would be unfair to force the taxpayer to pay tax on a "paper" gain.
The like-kind exchange under Section 1031 is tax-deferred but not tax-free. When the replacement property is ultimately sold and not involved in another exchange, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, would then be subject to tax.
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