*Excerpted from "Real Estate Flipping: Growing Rich Buying and Selling Property," by Mark B. Weiss, C.C.I.M., published by Adams Media.

Trading Up Using the 1031 Exchange

Despite rising real estate values across the country, property investors continue finding creative ways to make their investment dollars work for them. One of the most powerful methods for building real estate holdings includes the use of 1031 Exchanges, which allow investors to defer capital-gains taxes on investment property by reinvesting sale proceeds into the purchase of new property within a set timeframe. Though 1031 Exchanges have grown in popularity as the sheer number of active real estate investors has multiplied, 1031 misperceptions and misapplications continue. Here are answers to the seven basic 1031 Exchange questions.

* What is a 1031 Exchange?

Simply put, it is a tax avoidance tool that allows you to defer capital gains tax to a later date when selling a piece of investment property, thereby allowing you to reinvest money received from the sale into another property. You are, in essence, ‘exchanging” one property for another investment property of equal or greater value. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

* Why do a 1031 Exchange?

There are three primary advantages to investors for doing an exchange:

1) To grow your real estate portfolio: Deferring your tax burden is like getting an interest-free loan on the tax dollars you would have owed on your property sale.Your immediate tax savings is, thereby, used as investment capital in a replacement property.

2) To turn your “gain” into immediate equity and tax-free cash: The 1031 Exchange allows you to retain more equity, which lets you to shift into properties of increasingly higher value every time you perform a 1031. But, there’s an additional benefit. Once your old property is sold and the replacement property is purchased, you can turn around and refinance the new property, taking cash out as a loan for anything you need, and the money is not taxed as income.

3) To use as an estate planning tool: Families that intend to pass along real estate holdings typically deed them into a family partnership or LLC (limited liability company). Management income can continue to be drawn from the properties by the parent or principle, but heirs will inherit the property without taxation and “can continue to 1031 Exchange the property and grow a real estate portfolio,” according to attorney David P. Greenberger.

*Where do I start?

The first step is to identify real estate to purchase, and enter into a contract to sell your property. While you can sell your property to anyone you want for an exchange, you must identify in a written document signed by you and executed with a qualified 1031 intermediary, the property you plan to buy within 45 days of relinquishing your original property. The exchange, or final sale of the property, must be completed within 180 days after the transfer of your property. Sale proceeds must be held in an escrow account with an exchange agent, or qualified intermediary, until your “exchange” is complete.

There are no extensions available. Therefore, it is critical that you start searching for property as soon as you feel your sale is imminent, and try to time the closings accordingly, since 45 days goes by very quickly.

Is there a limit to number of properties that are identified in the 45-day period?

You can identify more than one property as a potential replacement property, but be mindful of the rules. You can identify up to three properties without regard to fair market value. Or, you may identify any number of properties provided that the total value does not exceed 200% of the value of the original property you are selling. You don’t have to close on all properties – and you may want to identify several in case the sale of any one falls through. But you must be in compliance with these rules …or you pay taxes!

Is there a limit to the number of properties I can “exchange?”

You can “exchange” a single property for multiple properties. Likewise, you can purchase just one property from the proceeds of several, as long as all the related timeline, identification and value rules are met. But note: proceeds not used to purchase new investment property are taxed as a cash sale. So, if you “exchange” only part of your original sale profits, you will be taxed on the remainder.

What are “qualifying properties”?

* Property exchanged must be of “like-kind,” which generally means property of greater or equal value. You can exchange a duplex for a five-story building or even a vacant lot, as long as you meet all other 1031 requirements, including the holding time required before re-selling real estate.

* Property exchanged must be held for productive use in trade, business or investing, which can include a residential rental property, strip mall, warehouse or land held for speculative investment. Personal residences or land a developer holds in inventory to sell later are not allowed. While it is possible for property purchased in an exchange to be converted at a later date to a primary residence, or for a vacant lot to ultimately be sold to a developer, it is tricky. So, it’s advisable for you to consult with a 1031 expert and wait at least two full tax years before doing so.

Trading Up with a 1031 Exchange

As you can see, the tax-deferred exchange is a great way to build up your net-worth and maximize your investment dollars. And there are many more nuances to the 1031 tool not covered in this article that sophisticated property investors regularly employ, such as using them in conjunction with “triple net leases.” But the regulations regarding 1031 exchanges are complex. They vary from state to state, and are subject to change by the IRS. Therefore, it’s best for property investors of all skill levels to speak with a professional trained in these transactions on a regular basis, as well as with your accountant, prior to engaging in a 1031 exchange. Once done, you will be able to trade-up on a tax-free basis and amass a substantial real estate portfolio using the tax code to your advantage.

* Excerpted from "Real Estate Flipping: Growing Rich Buying and Selling Property," by Mark B. Weiss, C.C.I.M., published by Adams Media.