The 1031 exchange

Section 1031 of the Internal Revenue Code is arguably the most powerful tax tool available to real estate investors. It lets you sell an investment property, buy another one, and defer all capital gains taxes — indefinitely. Some investors 1031 exchange their way through a dozen properties over 30 years without ever paying a dollar in capital gains tax. Then they die, and their heirs inherit at a stepped-up basis, erasing the deferred gain entirely. It is, by design, a wealth-building machine for patient landlords.

How it works

1. You sell your investment property (the "relinquished property").
2. The sale proceeds go directly to a qualified intermediary (QI) — not to you. If the money touches your bank account, the exchange is dead.
3. Within 45 days of closing, you identify up to three replacement properties in writing to your QI.
4. Within 180 days of closing, you must close on one or more of those identified properties.
5. The replacement property must be of "like kind" (any real property held for investment or business use qualifies — a warehouse can replace an apartment building).
6. You must reinvest all the proceeds and take on equal or greater debt to defer the full gain. Any cash you pocket ("boot") is taxable.

The qualified intermediary

The QI is the linchpin. They hold your sale proceeds in escrow and facilitate the purchase of the replacement property. You cannot use your attorney, your CPA, your real estate agent, or any other person who has acted as your agent in the prior two years. The QI must be a disinterested third party. Choose one that's bonded, insured, and keeps funds in segregated accounts. QIs are unregulated in most states — several have gone bankrupt holding client funds. Ask about their financial controls before you wire seven figures.

Common ways investors blow it

• Taking constructive receipt of the funds (having access to the money, even if you don't spend it).
• Failing to identify replacement properties within 45 days because the market was "too hot" or they got busy.
• Buying a replacement property for personal use (your vacation home does not qualify unless you meet strict rental requirements).
• Trading down — buying a cheaper replacement and pocketing the difference. That difference is taxable boot.
• Forgetting about depreciation recapture. A 1031 defers it, but it doesn't erase it. The recapture obligation carries forward to the replacement property.