The 1031 exchange (pronounced ten–thirty-one), also called a Starker exchange or a like-kind exchange, is a way of selling real estate and not paying any taxes until sometime in the (hopefully) distant future. Many people call it a tax-free exchange, but the more correct expression would be tax-deferred exchange.
Thanks to Mr. Starker, who was the first person to win on this issue against the IRS, you can avoid paying taxes at the time you sell property, but only if you follow the IRS rules exactly. There is no room for error. You will almost always need to hire a professional to handle these details for you, but the tax savings will more than pay for the professional fees.
First, you sell your property. The sold property is called the relinquished property. All the sale proceeds must be kept in escrow by someone called a qualified intermediary. Usually, this is a closing attorney or escrow company.
You have 45 days from the sale of your relinquished property to identify the new real estate you want to buy, called the replacement property. You officially identify the property by giving a written statement to the qualified intermediary. You can pick up to three properties to identify, but you must buy one of those properties within 180 days of the sale of your relinquished property or by the due date of the tax return for the year of your sale, whichever occurs first.
If you do everything exactly right, you do not pay any taxes for the year on the sale of your relinquished property. The technical details regarding other requirements can get pretty complicated.
For more information, you might want to read Publication 544, “Sales and Other Dispositions of Assets,” and Form 8824, “Like-Kind Exchanges,” both available at www.irs.gov.