What is a 1031 Exchange?
Under Section 1031 of the Internal Revenue Code (IRC), the IRS allows the exchange of like investment properties to deferring capital gains taxes.
Does a 1031 exchange go by any other name?
Yes, you may see a section 1031 exchange referred to on your exam as a tax-deferred exchange. So, for your real estate licensing exam, this is not a tax-free exchange, but a tax-deferred exchange.
Is my primary residence eligible for a section 1031 exchange?
No, only those properties that are of like kind can be exchanged. Such as those held for investment or the generating of income.
Can you explain this in English, please?
Sure, think of it this way. You are trading your business or investment property to someone else for another property. If you follow all the guidelines outlined in Section 1031 of the IRC, then you can defer paying any capital gains tax that would usually be due on the property.
So, what are those guidelines?
Okay, well we are dealing with the IRS here, so there are a few rules that have to be followed under a tax-deferred exchange. Firstly, the properties must be of like kind, and the trade must take place within a certain period of time, or it will not be an allowable Section 1031 exchange. Like kind meaning you cannot exchange your personal home for a gas station. That’s not an eligible exchange.
However, don’t the properties have to be the same value?
Yes, but they never are. So, the IRS allows those exchanging property to add personal property to the exchange. This is referred to as boot, and you have to know it for your real estate licensing exam. Boot can be cash or any other personal property which will be used to equalize the value of the properties involved in the 1031 exchange. While there is no current tax due on the real property being exchanged, the value related to the boot is taxable when traded.
What would a sample real estate license exam question about a Section 1031 exchange look like?
In conclusion, here is an excellent example of a question you are likely to see on your real estate exam related to a Section 1031 tax-deferred exchange:
The section of the federal tax code that permits investors to defer paying capital gains taxes on the sale of a property if they reinvest the proceeds in a like-kind property within a specified period of time is IRC Section _______:
Correct Answer: B
Explanation: Internal Revenue Code Section 1031 permits investors to defer paying capital gains taxes on the sale of a property if they reinvest the proceeds in like-kind property.
What else can help me prepare to pass my real estate licensing exam on my first attempt?
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