Simply put, Section 1031 of the Internal Revenue Tax Code 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 (or properties) 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.

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. This is of particular interest to those wishing to increase their portfolio. If the original property has had significant appreciation, the equity extracted from the exchange might be enough to afford multiple properties or a decent sized multiplex.
   
2. To turn your "gain" into immediate equity and tax-free cash:
   Once your existing property is sold and the replacement property is purchased, you can subsequently refinance the new property, and take cash out without having to pay income or capital gains tax. (Keep in mind your proceeds will be subject to taxation later -if and when you were to sell a replacement property without performing another 1031 Exchange.)
   
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). Heirs will inherit the property without taxation and can continue the 1031 Exchange process without interruption.

     The first step is to enter into a contract to sell your property and then identify a property for purchase. While the buyer can be "anyone," the prospective replacement property must be specifically identified in a written document signed by you and executed with a qualified 1031 intermediary. This must be done within 45 days of relinquishing your original property and the exchange, or purchase of the new property must be "closed" within 180 days after the transfer of your original property. Sale proceeds must be held in an escrow account with an exchange agent, or qualified intermediary, until your "exchange" is complete. Also, all equity proceeds from the sale must be reinvested in the replacement property.

     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. It might even behoove you to select more than one property (see restrictions in the next section) in case your first selection runs into problems.

     The 1031 requirements allow you to identify more than one property as a potential replacement. You can select 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 percent of the value of the original property you are selling. You don't have to close on all properties. Remember that you must be in compliance with these requirements, or you may find yourself subject to a hefty capital gains tax!

     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 requirements are met.

     Properties exchanged must be of "like-kind," which generally means property of greater or equal value. You may 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 reselling 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.