Section 1031 of the Internal Revenue Code (IRC) defines the 1031 exchange. 1031 exchange also known as Like kind exchange specifies that if an asset that is most often a land or a building, is sold and the proceeds of the sale are then reinvested in a similar type of asset then there is no gain or loss and the capital gains taxes are deferred.

A 1031 exchange is an ideal way to suspend the taxes that are immediately due after the first sale. For instance if an investor purchases a residential property for say $250,000 and sells it for $30,000 after 5 years, the profit of $50,000 which he incurs will be subject to capital tax. But if the profit so accrued is invested in another similar kind of commercial real estate, there will be no taxation on it. So his taxes will be deferred to some date in future.

1031 exchange is a source to save your money being spent in capital taxes, but on the same hand an individual should be careful and keep few points in mind before entering this exchange.

Before entering the 1031 exchange, whether as an investor or a seller it is better to do a little research and consult your tax advisor to get an estimate on your tax exposure.

Several assets such as boats, horses or cattle etc. qualify for the 1031 exchange but on the same hand only real estate can be exchanged for a real estate. So the real estate should be an investment property. A building purchased for renovations and selling and land purchased for construction of houses etc. cannot qualify for 1031 exchange because in such instances the owner does not intend to hold on to them for a period of time for investment reasons.

Further in order to have a cent percent tax deferment on the disposition of property, there are three basic steps to be followed. Firstly right after the sale of the original or relinquished property, it is necessary to acquire a replacement property as early as possible. The replacement property must be equal to or greater than the value of the relinquished property. Secondly those who wish to have 100% capital tax deferment must reinvest all of their net equity from the surrendered property in the replacement property. Finally one must assume debt on their replacement property that is equal to or greater than the debt on the original property. In case the debt on your replacement property is less than the debt on your original property then people seeking complete capital tax suspension should put in additional cash to balance the exchange transaction.

There are certain rules to identify an adequate replacement property. For instance according to the three-property rule you may identify up to three replacement properties overlooking their fair market value. You may not purchase all the identified properties but it is best to have alternatives in hand. While under the 200 percent rule you are allowed to identify more than three replacement properties only on the condition that the fair market value of these properties does not cross 200 percent of the contract price of the property sold. In the 95 percent rule if the fair market value of more than three identified properties exceeds 200 percent of the value of the original property, the exchange can still hold id the 95 percent of the total cost of all the properties on the list are purchased.