Section 1031 Overview
Section 1031 is a provision of the Federal Income Tax Code that allows companies and individuals to exchange property of a like-kind without payment of the capital gains taxes due. The provision has been in the law since March, 1921, and is well settled. Most* U.S. states follow Section 1031 with respect to their own capital gains taxes, however, even the few that do not allow resident taxpayers to exchange for property out of state will allow them to do so in-state.
Depending on the type of property involved, the words “like-kind” are either loosely or strictly construed: some types of property do not qualify at all. Loose standards apply to:
Real property is real estate…
- Located within the 50 US states or Washington, D.C. (both given and received).
- Must be defined as “real property” by your state (e.g. water rights are real property in some places and personal property in others).
- May be a leasehold interest, if more than 30 years remain.
- If outside the US, both the given and received properties must be such; no US-International cross-border exchanges are permitted.
If the property given (your Relinquished Property) and the property received (your Replacement Property) are both real property under the law of the state in which they are located there is no further test of similarity.
This explodes a common myth about real estate exchanges. Namely, that what you give and what you take must be virtually identical…
The property given can be land (in Alaska) and the property received can be a multi-family on a leased lot (with 30 years remaining) in Florida. This and similar exchanges will satisfy the like kind requirement.
Stricter Standards Apply to Personal Property
In general, personal property given and personal property received MUST match a four digit product code found in the Standard Industrial Classification Manual published by the U.S. Department of Commerce.
For example: If wooden chairs are given, wooden chairs must be received.
Why would a law permitting these tax benefits still be on the books?
The short answer is that it is not in the public interest for taxpayers to be frozen into their holdings for tax reasons; it serves no social good if you have a fair market offer for your property, which if consummated would lead to growth, jobs, etc. but which you cannot accept because of all the taxes that would be due.
Please review the section in this site entitled What Qualifies for a 1031 Exchange for more information.
Some states attempt to impose a state capital gains tax on nonresident exchanges, however, in many of these states a withholding waiver is available.