Investors can defer taxes that would have been payable on capital gains at a later date by utilizing a Section 1031 Exchange.

Effectively this means that a property investor who trades an investment property for one or more similar properties for investment use can then defer the payment of income taxes to the federal government and even defer some state taxes.

This is effective for any asset classified as ‘real property’ as long as it’s used for investment purposes, active use in a trade or business or for the production of income.

The logical basis behind the IRS allowing investors to use the Section 1031 Exchange is that the investor has sold a property and then reinvested the sale proceeds back into a buying a new property. The investor never actually received the sale proceeds in a form that gives the person any funds so the IRS doesn’t classify the capital gains as being taxable income.

Section 1031 Exchange put simply means that as long as the tax payer is exchanging one investment property for another property or properties or a like-kind then the IRS consider that the person hasn’t received anything that could be used to pay taxes with.

The capital gain was transferred from one asset to another, so that the IRS does not recognize any gain or loss as part of your taxable income.

Please don’t make the mistake of thinking that the Section 1031 Exchange means the same thing as ‘tax-free’. The fact remains that the tax you would have paid is deferred until such time as you do eventually sell the property you bought as a replacement for the first investment you sold.

At the point where, in the future you sell the replacement property, you should be aware that you will be taxed on the capital gain that you deferred, plus you may also be taxed on the additional gain that you made since you purchased the property.

Obviously, if you come to a decision not to sell, then you can actually continue to defer taxes that would have been payable on the capital gain as long as you keep the property.

The exchanges of shares in the different actions are not eligible. This means that if you sell a stock you need to exchange for more of the same stock to take advantage of Section 1031 Exchange and defer tax on any capital gain you have made.