A smart tax saving tool that is gaining popularity among the real estate investors by enabling them to defer the entire capital gains tax is 1031 Exchange. Established in 1990 by the Internal Revenue Code Section 1.1031, it gives them an opportunity to defer their capital gain taxes on the sale of a property by re-investing the proceeds into like kind of property. However, one needs to have complete knowledge of the terms and conditions that apply for 1031 Exchange, and how it works.

Some very basic things that one should understand about 1031 Exchange are that only business and investment property qualify for the tax deferral under Section 1031. Also, the properties involved in the transactions should be of like kind. The term like kind has often been misinterpreted to mean that if someone is selling an office of 1200 sq. ft. he should invest the money he gets from its sale to buy an office of 1200 sq. ft. only. However, this is not the case and this term has a very broad meaning. It actually encompasses any real estate held for productive use in a business or for investment. For personal property to qualify it must be depreciable and part of the daily operations of a trade or business, for instance automobiles, office equipment and furniture, machinery, computers, billboards, franchise licenses, and the like. 1031 Exchange does not cover cash, stock in trade or other property held primarily for sale, such as, stocks, bonds, notes or other securities or evidences of indebtedness, partnership interests, and certificates of trust or beneficial interests.

The real property to which the rules of 1031 Exchange apply includes raw land, single family homes, hotels, multi-family dwellings, factory and office buildings, shopping centers, farmland, and so on. Also, all the proceeds gained from the sale of a property should be transferred through a qualified intermediary and not by someone who is the beneficiary, so that no one can use this money for his own financial gain. To defer the capital gains tax, the proceeds should be re-invested in like kind of property, which should be of equal or greater value and equity than the exchanged property. Moreover, the time period allowed for the re-investment should be adhered to. After selling the property to be exchanged, a replacement property must be identified within 45 days and the exchange must be completed within 180 days.

Deferring all capital gains taxes is not the only benefit that one gains from 1031 Exchange. It also has some hidden benefits, such as, the provision for re-investing in another property can significantly add to ones assets. Moreover, as the property assets appreciate in value one can easily upgrade to a property of higher value with the additional cash flow. 1031 Exchange also provides the flexibility to exchange the rental properties that have appreciated in value in hot markets and re-invest into lesser-known areas that are expected to appreciate in value and become the next sizzling markets in the approaching years.