From First Tuesday
The Internal Revenue Code (IRC) §1031 reinvestment plan, also called a §1031 transaction or exchange, allows an owner to sell business-use or investment real estate and use the sales proceeds to purchase replacement business-use or investment real estate, called like-kind properties, without a tax on the profit. The reinvestment transfers the cost basis –– the original cost incurred to purchase and improve the property less deductions for depreciation and destruction –– remaining in the property sold to the replacement property purchased. This is an accounting matter of concern only to the investor and the Internal Revenue Service (IRS). [See first tuesday Form 171 and 354]
Implicitly, the §1031 reinvestment plan shifts the untaxed profit (or loss) on the sale forward to the replacement property purchased. Only on a later resale of the replacement property will the owner report (and pay taxes) on profit or loss, and then only based on the price received on the resale. Of course, on the resale of a replacement property, the net proceeds may again be reinvested to purchase other §1031 real estate and further defer profit reporting and taxes. [See first tuesday Form 301-1]
The profit taken on the sale of real estate qualified as §1031 like-kind property –– business-use or investment property –– is exempt from state and federal income taxes when the owner purchases §1031 like-kind property as a replacement.
Two classifications of real estate make up §1031 like-kind property:
- investment property, called capital assets [IRC §1221]; and
- business-use property, which is trade or business property held for productive use. [IRC §1231]
Investment property includes:
- rental real estate, residential and commercial;
- vacation homes held for profit or resale; and
- investment (portfolio) real estate. [IRC §1221]
Business-use property is real estate used to house an owner’s trade or business and includes hotel or motel operations.
However, before business-use property qualifies as like-kind property, it must be owned for at least one year before it is sold or exchanged. Business-use property is unlike investment property, which has no holding period requirement. After one year of ownership, the business-use property may be sold and replaced in a §1031 reinvestment plan by purchasing either business-use property or investment property. [IRC §1231(b)(1)]
Similarly, investment property may be sold and replaced by either business-use property or investment property in a §1031 reinvestment plan.
Conversely, while a principal residence is a capital asset, it does not qualify as §1031 property since it is neither used in a business nor held for investment purposes.