A 1031 exchange is a method by which you can trade real properties with another person or business, avoiding capital gains taxes that are incurred in any typical sales transaction. The property that is exchanged must be held for productive use in a trade or business or for real estate investments.

In addition, the two properties must be of like kinds – that is, the properties must both be real estate held within the United States, or personal property exchanged must be of like kind or like class and also held within the United States. The like kind rule in the latter case can be very esoteric – for instance, in the case of cattle a bull and a cow are not considered like kind – so make sure you read the laws carefully.

Your 1031 exchange defers the payment of both federal income tax and certain state taxes, depending on your state, on the real estate investment transaction. It's based on the idea that, because you have not gained liquid cash but only another property in the trade, you do not have the cash to pay taxes incurred and therefore it would be unfair to require you to give the government a portion of the proceeds (of which there are none.) While your investment is the same before and after the exchange, the form of your property has changed.

1031 exchanges are used to postpone and, in some cases, eliminate taxes that would normally trigger a capital gains tax charge. In the same manner, any gain you would have obtained from depreciation recapture on the real estate investments involved is also deferred. This rule allows you to reallocate investments or swap around your business while not becoming immediately liable for a capital gains tax. By keeping that money in your pocket for now, you in effect get an interest-free loan from the government in the amount of the tax they are not assessing immediately. In addition, a 1031 exchange reduces the potential risk for both parties and any involved intermediary of tax consequences.

How 1031 Exchanges Work

Before the 1031 exchange rule came into effect, deeds to properties being traded were transferred into the name of an intermediary, capital gains on both sides figured, and then the deeds were transferred again into the names of the respective new owners. Real estate investments using this rule are now direct-deeded – that is, they are put directly into the names of the new owners.

Even though you are direct deeding your real estate investments in this exchange, you still need to work through a qualified intermediary who should have an agreement with both sides in the 1031 exchange about precisely what is being transferred. Usually, your intermediary is the commercial real estate agent who helped both parties find one another for the transaction.

Your 1031 exchange transaction can be a simultaneous exchange, delayed exchange (when there is a gap in time between transfer of the relinquished property and acceptance of the gained property), build-to-suit (when the customer can build on the replacement real estate investment property using exchange proceeds), or reverse exchange, which is the opposite of a delayed exchange. Make sure that any non-simultaneous exchanges can be completed within 45 days, or you may lose your tax advantages.

Remember, when you do a 1031 exchange, you are only deferring your capital gains. If you later sell the real estate investment property, you will have to pay your capital gains on it.

What To Watch For In A 1031 Exchange

If you want to get the whole value of the deferred capital gains, only trade your property for one that is of equal value or greater value than the original property, and that has equal or more equity. If you trade down instead, you will be liable for capital gains on any monies your trade partner pays you for the property you're getting rid of. For that matter, any cash that exchanges hands will incur capital gains tax.

You must be prepared to pay any incidental taxes or closing costs on your 1031 properties at the time of deed transfer. In most states, real estate investments will incur some costs during any transfer. Ask your intermediary or real estate agent what kinds of costs you can expect, and plan for a little extra just in case.

Your new property must be held for at least a year to be sure of avoiding capital gains tax on it. If you are using your 1031 exchange to pick up an real estate investment property that you want to turn into a residence or vacation home, wait that year before doing so. Tell your intermediary of your plan as well; there may be other rules that apply.

Make sure your qualified intermediary in the transaction has done 1031 exchanges before without a problem. These transfers of real estate investments can be very esoteric with some strange rules governing them, and it takes an expert to do it properly.