A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, is a tax deferral strategy that allows real estate investors to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into a new, like-kind property. Here’s how it works:

1. Like-Kind Property: The properties involved in the exchange must be of “like-kind,” meaning they must be similar in nature or character. This generally means that both the property sold and the property purchased must be used for investment or business purposes, rather than personal use.
2. Timing Requirements:
   • Identification Period: After selling the original property, you have 45 days to identify potential replacement properties. The identification must be in writing and must include specific details about the properties.
   • Exchange Period: You must close on the replacement property within 180 days of the sale of the original property, or by the due date of your tax return for the year in which the sale occurred, whichever is earlier.
3. Qualified Intermediary: To facilitate the exchange, you typically need to work with a qualified intermediary (QI) or exchange facilitator. The QI holds the proceeds from the sale of the original property and uses them to purchase the replacement property. This ensures that you do not receive the cash directly, which would otherwise trigger immediate capital gains taxes.
4. Deferred Taxes: By following the rules of the 1031 exchange, you can defer the capital gains taxes on the sale of the original property. However, if you eventually sell the replacement property without doing another 1031 exchange, you’ll be liable for the deferred taxes.
5. Basis Adjustment: The basis (value) of the new property is adjusted to reflect the deferred gain from the original property. This means that when you eventually sell the replacement property, the deferred gain will be factored into the capital gains calculation.
6. Boot: If you receive cash or non-like-kind property as part of the exchange, it is referred to as “boot” and is subject to taxation. To fully defer taxes, you need to reinvest all proceeds into the new property and avoid receiving boot.

The 1031 exchange can be a powerful tool for real estate investors looking to defer taxes and continue growing their investment portfolio, but it requires careful adherence to IRS rules and deadlines.