Generally, when you sell property and have a gain, taxes must be paid on that gain at the time of the sale. However, there is an exception under Section 1031 of the Internal Revenue Code that allows you to defer paying taxes on potential gain when you sell your investment property and reinvest the proceeds in a new property. It is important to keep in mind that the gain postponed in a 1031 exchange is tax deferred and not tax-free.
In order to fall under this exception, both properties involved in the transaction must be "like kind" properties, meaning that both properties must be held for use in a trade, business or for investment. The 1031 exchange can include "like kind" property exclusively, or it can include "like kind" property coupled with cash or not "like kind" property. However, there may be a taxable gain if you receive cash or not "like kind" property. It is important to note that the proceeds from the sale of the relinquished property must go to a qualified intermediary, and cannot be held by you or one of your agents.
Not all investment property can be used in a 1031 exchange. Stocks, bonds, notes and partnership interests are among the types of property that are excluded from Section 1031 treatment
In order to enjoy the tax deferment offered under a 1031 exchange, there are two time limitations that must be complied with. First, you must identify the potential replacement property you wish to purchase within 45 days of selling the relinquished property. Second, you must receive the replacement property within 180 days of selling the relinquished property. These time limits are very important since they are not extendable and must be complied with in order to qualify as a 1031 exchange.
If set up properly, a 1031 exchange is a successful way to defer paying taxes on potential gain that you would have otherwise had to pay taxes on under the Internal Revenue Code.