The term 1031 Exchange is defined under section 1031 of the IRS Code. (1) To put it simply, this strategy allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained by the sale of the first property. We’ll discuss like-kind property in more detail in section four.
Lee ISG President, Robert Leveen explains that this strategy has more benefits than just saving yourself from taxes.
According to Leveen, a 1031 exchange can allow a real estate investor to shift the focus of their investing without incurring the tax liability. For example, perhaps you are investing in properties that are low-income and thus high-maintenance. You could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps you want to move your investments from one location to another without the IRS knocking. The 1031 makes this possible. (2)
Note: Traditionally, a 1031 exchange is where one property is literally swapped for another property of like-kind. However, the likelihood that the property you want is owned by someone who wants your property is really, really unlikely. According to Forbes, this is why “the vast majority of exchanges are delayed, three party, or Starker exchanges (named for the first tax case that allowed them).
In a delayed exchange, you need a middleman who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. This three party exchange is treated as a swap.”