by Talea Jurrens

Created on: August 11, 2008   Last Updated: January 15, 2012

If you are interested in investing you may have heard the term 1031 exchange mentioned in conversation. Perhaps you are interested but the lack of information has left you wondering what the heck that means exactly. It sounds like it might be something really complicated. Your imagination begins to run wild with possibilities. Is it the opportunity to invest in a remote piece of highway somewhere in Idaho? Could it be the chance for a real life game of Monopoly by buying your own railroad line? Both are interesting possibilities but neither have anything to do with a 1031 exchange. A 1031 exchange is actually a more tangible investment tool that can help you in building wealth. This doesn't mean you have to exchange 1031 cents-off coupons with your friends. It means that Section 1031 of the Internal Revenue Code provides investors a way to defer capital gains tax when they are buying and selling investment property. With that revelation I'm sure you're probably intrigued. In order to satisfy your curiosity lets explore further.

The use of 1031 exchanges in not a new concept. It has been around since the 1920s and is a well established means of creating financial leverage. By deferring the capital gains tax on a property sale you are able to reinvest the full amount of your proceeds. Any honest and legal means of creating financial leverage has to be a good thing, right? What's even better is that it's a pretty simple process. At this point I can hear you breath a sigh of relief. When I mentioned taxes you were probably thinking that you were going to have to exchange 1031 forms with the IRS to get this thing done. The only catch is that you have to follow a fairly strict set of rules and an even more rigid timeline.

In order to get started there are a few specific requirements that you must meet. For example, there must be at least two properties or sets of property to exchange. This will be the property you are selling and the property you are buying. The exchange properties must also be investment properties of like kind and must be used in trade or business. Property that you own for personal use will not qualify. In order to defer the capital gains tax, the property to be purchased must be of equal or greater value to the property being sold and you must reinvest all of the sale proceeds. Another strict rule is that you must use an independent middleman, often referred to as an accommodator, to hold funds in "escrow" as the exchange is being completed. This accommodator will help guide the process and provided the documents to enable qualification for the exchange. Be sure to choose someone who is very reputable. A written agreement with accommodator must be signed before closing on the property to be sold. You must identify a replacement property within 45 days after closing on the property that was sold and purchase a replacement property within 180 days of that same closing. There are other variables to consider when making the exchange but this overview should help you better understand how it works.

Now that you've got the basic facts, you may be wondering if a 1031 exchange might be right for you. Each situation is different and it would be a good idea to talk to a financial advisor, investment councilor, tax advisor or a knowledgeable realtor for more information.

* Please note that this article is provided for informational purposes only and is in no way meant to be financial advice.

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