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Trading Up

The basics on Section 1031 exchanges.

Afraid of the capital gains bill you'll pay unloading business or investment property that soared in value during the real estate boom? Don't sell--swap. A Section 1031 exchange allows you to sell a property used for business or investment and reinvest your gains in a second property--also used for business or investment--without paying taxes on your profit, says Derrick Kinney, senior financial advisor with Ameriprise Financial in Arlington, Texas.

Permissible since 1990, 1031 or "like kind" exchanges have increasingly come into favor, thanks to soaring property values. "The buzz around these is just beginning," says Kinney, who notes that exchanges offer a way to address the tax problem highly appreciated property can present.

A 1031 exchange won't enable you to cash out of your real estate investment, nor can it be used for a primary residence. But it will let you trade in a holding that may have peaked in value for one in a more promising location.

The caveat? Satisfying the IRS means meeting multiple technicalities, among them closing on your new property within 180 days of selling your current one and having a qualified intermediary handle the sale and purchase. "It's a complicated process, and you may pay up to 0.25 percent of the selling price in fees [to an intermediary]," says Kinney, who strongly urges property owners to undertake a 1031 exchange only with the advice of a tax consultant. "But the tax savings by far outweigh the effort and expense involved."

Jennifer Pellet is a New York City freelance writer specializing in business and finance.

This story appears in the August 2006 issue of Entrepreneur. Subscribe »