A 1031 exchange is a tax-deferral tool for commercial real estate owners. Section 1031 of the Internal Revenue Code provides the basis for a 1031 exchange. With a 1031 exchange, an owner can defer capital gains taxes by reinvesting the proceeds from the sale of a property in a like-kind property. Key rules for 1031 exchanges include the following:
- Property must be considered "like-kind." Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.*
- The real estate owner is forbidden from taking funds from the closing. Profit from the property sale must be transferred to a certified exchange agent, who then transfers the funds to the settlement for the replacement property.
- Within 45 days of selling the original property, the real estate owner must identify in writing the replacement property they plan to purchase for the 1031 exchange.
* Source: https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real- estate-tax-tipsOne disadvantages to a 1031 exchange is that it reduces the basis for depreciation on the replacement property.