A 1031 exchange, also known as a like kind exchange, is a transaction under United States law which specifies that if an asset (usually some form of real estate such as land or a building) is sold and the proceeds of the sale are then reinvested in a like kind asset, then no gain or loss is recognized, allowing the deferment of capital gains taxes that would otherwise have been due on the first sale. This law is defined by section 1031 of the Internal Revenue Code, 26 U.S.C.  1031.

In order to qualify for this exchange, certain rules must be followed.:

  1. Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
  2. The asset must be of like kind. Real property must be exchanged for real property. Personal property must be exchanged for personal property.
  3. The proceeds of the sale must be invested in a like kind asset within 180 days of the sale. However, the property must be identified within 45 days.

Frequently, the most difficult component of a 1031 exchange is identifying a replacement property within the first 45 days following the sale of the relinquished property. The IRS is strict in not allowing extensions.

A 1031 exchange is similar to a traditional IRA or 401K retirement plan. When someone sells assets in tax-deferred retirement plans, the capital gains that would otherwise be taxable are deferred until they begin to cash out of the retirement plan. The same principal holds true for tax-deferred exchanges or real estate investments. As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deffered. Unlike the aforementioned retirement accounts, rental income on real estate investments will continue to be taxed as net income is realized.