Section 1031 of the Internal Revenue Code states that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business. In a typical real estate transaction, the property owner is required to pay taxes on any profits gained from the sale of the property. When the real estate transaction is conducted through a 1031 exchange, the taxes owed on the profits of the sale are deferred until a later date.

The property owner "trades" one or more properties for replacement properties of the same type while deferring the payment of the taxes required by the transaction. The taxes are deferred, not eliminated, and will be subject to payment whenever the replacement property is sold.

Real estate investors use the 1031 exchange as a way to avoid paying taxes on the sale of properties. By deferring the taxes until a later date, the investor is freeing up capital for the purchase of more properties.

Types of Exchanges

There are several types of exchanges that an investor can use. The first is called a simultaneous exchange. In this type of exchange, the investor exchanges their property for the replacement property at the same time. In a delayed exchange, there is a gap in the time between the transfer of the investor's property and the acquisition of the replacement property. This is the most common type of 1031 exchange. There are also build to suit exchanges, reverse exchanges, and personal property exchanges to consider.

Requirements for Valid Exchange

There are several requirements that must be met for the 1031 exchange to be valid. Certain types of property cannot be used for a 1031 exchange, including property that is primarily held for sale and the taxpayer's personal residence. Both properties in the 1031 exchange must be used productively in a business, trade, or investment. Both properties in the exchange must belong to the same real estate category and be exchanged for other properties, not cash to purchase other properties.

To defer taxable gain, the value, equity, or debt of the replacement property must be equal to or greater than that of the investor's property and all of the proceeds acquired must be put toward the acquisition of the replacement property. Once the proceeds have been placed into the exchange account, they can only be withdrawn according to the rules of the 1031 exchange.

After the investor's property has been transferred, the investor must find suitable replacement properties within 45 days and must complete the exchange within 180 days. If the investor does not find suitable properties and complete the exchange by the end of the time limit, the exchange fails and the investor is responsible for paying taxes on the sale of the property.