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A 1031 exchange is a nifty, if complicated, little tool to defer paying taxes on a recently sold property. The skeletal outlines of a 1031 exchange are fairly straightforward – whenever you sell property, you pay a property tax. But, through a 1031 exchange, you can purchase a like-kind residence with proceeds from your previous settlement, tax-deferred. So effectively, if you continue to reinvest the money earned in a real estate deal into more like-kind real estate, you won’t have to worry about paying taxes on the value of the sold property.

The two types of taxes faced by selling property are a capital gains tax and a depreciation recapture. A capital gains tax is fairly straightforward–if you made any positive gains from your investment in your property, you pay a tax on the money earned. Depreciation recapture, on the other hand, is the government’s attempt to offset any cumulative depreciation you may have taken on your property, as all these deductions are considered taxable income upon selling the property.

“Like-kind” is a phrase that confounds a lot of people when trying to understand a 1031 exchange. A like-kind exchange is an exchange that involves the selling of one property and purchasing of another with “the same nature or character.” So if you have a personal residence and want to sell it and make the proceeds part of a 1031 exchange to buy some office building–you will be declined. However, if you have a four-bedroom duplex at the beach you rent for the season and want the proceeds to go to buying an office building–that’s acceptable. The difference is that your rental home is technically a business and so is of like-kind with an office space.

If your goal is to completely defer all taxes on proceeds taken from a sale of real estate through a 1031 exchange, there are two steps you must follow. First, you need to make sure the property you purchase has the same cost or costs more than the previously sold property. Next, if the property you’re selling has a mortgage on it, you are required to use the amount of debt, or more, in the new property. If you earned $250,000 and had a $100,000 mortgage, you’d have to invest in a property worth at least $350,000 to defer your taxes via a 1031 exchange entirely.

Time provides another pivotal element in determining a 1031 exchange. You can not simply sell one property and intend to buy another. Two critical time limits determine whether your exchange is acceptable. Initially, you have 45 days from your initial property sale to determine which new, like-kind property (up to 3) you will be purchasing. Simultaneously you have 180 days from selling to purchase a new like-kind property for the 1031 exchange to be upheld.

1031 exchanges are a complicated procedure with many, many little details and rules to follow. There are specific partial exchanges, reversal exchanges, simultaneous exchanges, and many more. If you’re interested in pursuing a 1031 exchange, be sure to consult a financial advisor for support.