Investors who own properties that have appreciated significantly and investors who have written off a portion of an investment that has depreciated, both face a similar problem when considering making a sale: capital gains taxes. Those with properties that has increased in value may face large capital gains taxes on the property's increased value, and others will be faced with a depreciation recapture tax on the funds that were written off each year.

Both kinds of investors can benefit from a 1031 tax deferred exchange. Under section 1031 of the IRS tax code, investors can defer taxes on gains in business or investment properties by rolling gains over into another similar ("like kind") property.

The IRS created the tax-deferred exchange to encourage continuous investment. The folks in our government knew that imposing capital gain taxes when people sold an investment property would make people want to hold onto those properties. In addition to discouraging those people from selling, those capital gains taxes would make investors think twice before buying more property. With the 1031 exchange, the IRS encourages the continuation of real estate investments.

There is no limit on the number of exchanges an investor can execute. Many investors continue a series of 1031 exchanges throughout their lives. At the time of death, their heirs get the property without paying taxes on the capital gains incurred by the initial investor.

What Properties Qualify?

Only certain kinds of transactions qualify under section 1031 of the tax code. The most important factor is that the exchange must be between two kinds of "like kind" property. This doesn't mean that land can only be exchanged for land, or a business complex can only be exchanged for another business complex. It would mean, however, that one U.S. investment property could only be exchanged for another U.S. investment property or properties.

Secondly, the property must be used for either business or investment, and it must be held for cash flow purposes or for long-term appreciation, and not for quick resale.

Finally, a third party facilitator is required for one of these exchanges unless all steps in the exchange occur on the same day. This is very difficult to accomplish, so it's likely you will need a facilitator or exchange accommodator. These third party facilitators are typically paid a fee of $500 to $1,500 per exchange.

If you don't plan carefully, you won't get a full tax deferral. To ensure that all of the taxes will be deferred, the property you buy must be of equal or greater value than the property you're selling. Also, equity from the old property must be rolled over into the new property, and the investor must incur equal or greater debt on the replacement property. However, it may be permissible to offset the debt with a cash infusion instead.

What is the process?

During the process of escrow on the old property being sold, the investor should contact a third party facilitator and draw up an exchange agreement. When the sale on the relinquished property closes, the facilitator holds the proceeds.

Next, the seller has 45 days from the closing to identify at least one- and up to three- potential properties to replace the one relinquished. If the investor has relinquished more than one property, deadlines are based on the date of the first closing.

The next deadline is 180 calendar days after the closing on the old property. By this time, the investor must close on at least one new property. However, this can be complicated if the exchange is done close to tax time. If the end of the 180 days would be after the investor's deadline for taxes (usually April 15), the investor must pay by the tax deadline, which may mean the deadline is considerably shorter than 180 days.

Once the purchase of the new property is completed, the third party facilitator transfers the money and ownership of the property back to the investor, and the 1031 tax deferred exchange is finalized.