A 1031 exchange lets you defer payment on all capital gains taxes when you sell a property and use the proceeds to invest in another similar property.
It's like an interest-free loan from the IRS, and it has one added benefit - it allows you to reinvest ALL of your equity in a new property, meaning you can afford more investment property. Thus, the real benefit of a swap is in its ability to increase your buying power.
For simplification, we'll call the real estate sold by the investor (the relinquished property) the old real estate, and we’ll refer to the purchased property as the new property. The process of exchanging will be called trading up because you can, in fact, trade up from a single family dwelling to a multi-unit apartment complex, or from a vacant lot to a commercial building.
For example, if you earn a capital gain of $250,000 on a property and merely sell it off, you only get what's left after the taxes are paid. If the total tax liability was $60,000 when the property was sold, you would only have $190,000 in your pocket to invest.
But if you take advantage of the 1031 exchange, you would have the entire $250,000 to invest in a new property, as the taxes owed would be deferred. There are two main timelines for trading up.
The reverse exchange happens when you close on the purchase of the new real estate before closing on the sale of the old. Investors sometimes exercise this option if they are property hunting in a seller's market. If the investor is eyeing a property, which has received many offers, they may want to act fast to close the deal.
This is the most common 1031 format, giving an investor up to 180 days to purchase the new real estate. It requires the services of a professional qualified intermediary to prepare and process the paperwork, and it also requires you to make your choice of a new property within 45 days. This choice is referred to as identifying the property.
Actually, when you sell the old property and agree to trade up to a new one in exchange for deferment of your capital gains tax, you have 180 days or less to complete the deal. The letter of the law states that an exchanger has a maximum of 180 calendar days, or until their tax filing deadline, whichever comes first.
Furthermore, the time constraints for identifying the new property are very specific, giving you until midnight of the 45th day after closing on the sale of the old property to choose the new one. This 45-day deadline is called the identification period and is part of the 180-day swap period.
Both options allow you to reinvest more of your equity, but each has its own merits. A delayed exchange buys you some time to shop around and/or get your ducks in a row, but a reverse swap frees you from worrying about deadlines - and stops you from drawing big circles on your wall calendar.