Established for real estate barons and tycoons, 1031 exchanges have been around since the 1920s. Named for the IRS code which refers to them, the tax-saving tool also known as "flipping" or a "like-kind" exchange has been gaining traction as a way for Americans to save money on taxes from property, by deferring them to another, newly-purchased property.



1031 exchanges are a simple concept surrounded by not-so-simple details. If you own a piece of property, and you wish to sell it and buy another piece of property of equal or greater value, you can defer your capital gains taxes by performing a "like-kind" exchange.

Both the property you sell and the new property you buy must meet certain requirements.

Both properties must be held for either investment or business use. This can include property that is rented out. Their uses can be interchangeable though. For instance, a piece of raw land can be exchanged for a rental property. Agricultural real estate can even be exchanged for office buildings, apartments, or storage facillities. The like-kind rules are fairly flexibile when it comes to exchanges of real estate.

To obtain a complete deferral of the income taxes, all of the profit made from the previous property must be immediately re-invested in the new property, which must cost the same or more than the former property. Sometimes this can happen simultaneously, but most of the time a delayed exchange must take place.

Once the former property is sold, the investor generally has 180 days to close on a new one that meets the criteria. During the 180 days, a qualified intermediary must handle all of the assets involved and carefully organize the exchange. You must also specifically identify a replacement property that you plan on purchasing within 45 days of sale date on the original property. However, you can identify more than one potential replacement within this timeframe.

There are several other detailed limitations to the type and value of the replacement property, so it's best to ask a financial professional for more details. By way of example, you would need to file a tax return extension in cases where the sale of the original property occurred later in the year (e.g., October through December) and the deadline for filing your taxes arises prior to the general 180 day closing deadline. However, this would not be required in cases where the 180 day deadline occurs before the normal tax return filing date.

In some instances, you can also flip property the opposite way. If you happen to find new property you want to purchase before you sell your old investment, you may qualify for a "reverse exchange." You still defer your capital gains taxes to your new property; you just do it in the opposite order.

In all cases of flipping, you must have what the IRS has deemed an "exchange accommodation titleholder" who actually holds on to the assets involved in the purchase.

One advantage of the exchange is that in theory, you may avoid paying capital gains taxes forever. If you keep the properties your entire life, upon your death your family may be allowed to sell the property, capital gains tax free. Another significant advantage of the exchange is that it provides taxpayers with ability to accummulate additional tax-deferred equity through the use of borrowing, provided that the taxpayer continues to reinvest proceeds from sales in property of higher value.

Because of the complexity of 1031 exchanges, it's important to have a financial professional familiar with real estate by your side. A lawyer is generally recommended as well. But depending on your situation, the complexities may just be worth the tax savings you could receive.

A legal and ethical way to put off paying Uncle Sam for as long as possible. Now that's a technique that would make most 1920s tycoons proud.