A 1031 Exchange, also known as a "Like-Kind Exchange," refers to a section of the internal revenue code that promotes the liquidation of a particular asset in concert with the purchase of another asset, and defers tax liability associated with the first asset.
An example of this can be found in real estate, in which a home is sold and a new home is purchased with the acquired capital. (The same concept would apply to the purchase and sale of a business)
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There are a number of reasons why the government provides the tax benefit inherent in a 1031 exchange. First, it encourages buyer and seller activity in the real estate market, which in turn aids in stimulating the overall economy. As such, tax-deferred ventures provide an incentive to become involved in buying, trading and exchanging since the cost of the tax debt on the capital gains is put off until the investor takes cash out of a future disposition.
Please note: proof of this exchange acquisition is provided to the IRS in the form of a detailed submission of a Form 8824. There are certain conditions that must be met in order to alleviate the tax liability of the first sale. Proof of meeting these conditions are to be outlined in the aforementioned form.