Put simply, 1031 Exchanges — often called "Deferred Exchanges" — enable owners of business and investment real estate to sell their property and buy other similar type property without paying the capital gains tax. These similar type propeties are referred to as "like kind." They allow the investor to continue his or her investment in another property without losing investment equity to taxes. A key advantage of a 1031 Exchange is that you can defer capital gains indefinitely. No limit is placed on the number of such exchanges in your lifetime. One can start out with a small income property and regularly exchange it for larger properties.

Continuing to exchange investment-type proeprties insures that you never have to pay taxes on your real estate capital during your lifetime. (It's important to note that this is for an equal value exchange. Any extra that is above the trade price is referred to as "boot" and is taxable.) In a nutshell, the total purchase price of the replacement "like kind" property must be equal to, or greater than the total net sales price of the relinquished, real estate, property.

Your heirs may even be entitled to receive a stepped-up basis on your investment property and avoid paying taxes on the capital gains you deferred throughout your lifetime

The term "1031 Exchange" actually refers to the Internal Revenue Service code which went into effect in mid-1990. The "like kind" provision has a broad range. It can include land, rental, and/or business property — any of which, can be exchanged for the other.

The rules also require that the "Exchanger" use a safe harbor to hold the proceeds while the exchange is in progress, and explains what those safe harbors are. The most common and practical safe harbor is a "Qualified Intermediary."

The rules also require certain time frames and other requirements, all of which are available through the IRS.

Other popular advantages of a 1031 exchange include:

Trading up by buying a bigger property or increasing the overall amount of your real estate investment — and/or buying a higher-quality property.

Leveraging: putting as little of your own money as possible down on a property, and maximizing the financing. (Best in a strong market.)

Buying a larger or more valuable property for the additional depreciation. (The adjusted basis of the relinquished property transfers to the replacement property.)

Exchanging a high maintencance and/or high turnover property for something with lower turnover and maintenance requirements.

Upon having to relocate, one can exchange for another property most anywhere in the U.S.

Note: This article is intended for general information purposes only. Please consult an attorney, tax advisor, or accountant for advice.

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