A Section 1031 Exchange is a form of like-kind exchange that allows an investor to defer paying capital gains on a property purchased as an investment as long as the gains were applied to a new, like-kind investment. Simply put, instead of 'cashing out' an investment and paying taxes on the gains, you can roll the gains over into a new investment and avoid the tax penalty.
Rules for 1031 Exchanges:
Like-Kind Property- To qualify as a 1031 exchange, the property sold and the property acquired must both be "like-kind," meaning that both of the properteis are of the same nature and character, even if different in quality.
Investment Property Only- The 1031 exchange rules do not include primary residences and only for the same tax payer.
Greater or Equal Value- To completely avoid paying any taxes upon the sale, the net market value of the property purchased must be the same as or greater than the one sold. If not, you can not avoid 100% of the taxes owed. If the property acquired is of a lessor value, the difference is the "boot" and capital gains taxes will be owed.
180 Day Purchase Window- To qualify for a 1031 exchange you must purchase all new properties within 180 calendar days (6 months) following the closing of the original property.
There are four basic types of 1031 Exchanges:
Simultaneous- Very rare in today's market, this exchange is when there is a direct exchange of properties between two parties. Of course, it is very rare that the person who owns the property you want also wants to purchase the property you own.
Delayed Exchange- The most common form and one in which the investor sells their property and then close on a replacement property within six months.
Reverse Exchange- Though simple in nature, the reverse exchange is actually quite complicated to perform. A reverse exchange means that you buy first, and pay later. However, Section 1031 requires that this type of purchase be made in cash and most banks own't lend to you. because of title concerns.
Construction/Improvement- An investor can purchase a new property that is of lower cost than the original property and use the additional funds to improve/build on the new property, thus still avoiding capital gains taxes.