It’s been called the most powerful wealth-building tool available for U.S. taxpayers. And that says a lot.

Thousands of financial wizards, real estate barons, and budding investment gurus have taken advantage of IRC Section 1031, which allows a taxpayer to sell an investment or business property and replace it with “like-kind” property while deferring federal and state capital gains taxes.

The Code reads: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind, which is to be held either for productive use in a trade or business or for investment.”

Sounds simple enough. Let’s look at it.

“It’s a way to structure what would otherwise be a taxable sale and reinvestment of proceeds as an exchange,” said Andrew Gelson, managing director of Compass Exchange Advisors, a subsidiary of Rockland Trust that specializes in 1031 transactions. “The underlying policy is that today is not the appropriate day to collect tax because the taxpayer has reinvested the funds from the sale of one asset into another that’s considered to be ‘like-kind.’ So the tax liability on that property is transferred to the new property and the immediate obligation is deferred.”

In other words, since the taxpayer is swapping the relinquished property for another—the replacement property—there’s no cash received by the taxpayer that could be used to pay taxes.

This option for investors has been around for decades, but in the early 1980s, courts and Congress found that investors in some cases were taking years—sometimes as much as a decade—to complete the exchanges that were generally supposed to happen simultaneously.

In 1984, Congress added strict time constraints of 45 days to identify a property and 180 days from the day of the sale (or 135 days from the end of the 45-day period) to acquire the new property.

“They don’t exactly make it easy,” said Michael V. Scanio, managing partner for Cambridge Capital Advisors in Newton. “That’s why you need experienced professionals.”

The process, Scanio said, is not terribly complicated but it’s not something you accomplish with home tax software.

Scanio’s company will act as an investment sales broker in most transactions, aiding the investor in locating qualified properties and providing all the customary services in a typical transaction.

The IRS requires, however, that a “qualified intermediary” be involved—in most cases a bank or financial subsidiary—that will insure compliance with the applicable laws as well as escrow all funds.

“In a 1031 transaction, you can’t receive the money from the sale,” said Scanio. “The intermediary receives and holds (the money), files all the paperwork with the IRS, and insures you’ve adhered to the letter of the law. When they’re ready to close, the money comes from the bank and if there’s additional equity needed, the individual or institution can post that.”

Theoretically, an individual investor could defer capital gains indefinitely until death, and avoid them altogether if the property passes to their heirs or estate.

In most cases, though, investors—both individuals and institutions—utilize the 1031 option in particular situations for a limited amount of time.

“Most people don’t buy property just for the sake of buying it,” said Scanio. “There is always a business plan and most likely an end strategy so eventually the taxes will be due. But this is a very effective way to defer the obligation and build wealth.”

While Scanio specializes in real estate transactions and, more specifically, shopping centers and single-tenant net leased properties, the 1031 Exchange is utilized by taxpayers in many other categories, according to Rockland’s Gelson.

Many assets qualify for exchange

“We’ve done exchanges on many more interesting types of assets,” he said, providing a varied list of assets that could qualify for “like-kind” exchanges including:

• Artwork

• Antique automobiles

• Vehicles, construction equipment, railroad rolling stock

• Horses, both racers and jumpers

• Aircraft

• FCC licenses (radio and TV)

• Franchise rights

• Beer distribution rights

• Oil and gas properties

In fact, it might be easier to comprehend what wouldn’t qualify under IRS rules. A personal residence would not and, generally, neither will a fix-and-flip property because it fits into the category of property being held for resale.

Vacation or second homes, which are not held as rentals, won’t qualify; however, there are cases in which an investment property can be used for personal use for a short period of time and even converted to full-time personal use. These are yet more reasons why an expert should be consulted.

Property purchased for resale does not qualify for tax-deferred treatment. Stocks, bonds, notes, inventory property, and a beneficial interest in a partnership are not considered eligible for a Section 1031 Exchange.

Gelson says there are three basic types of 1031 transactions.

Forward exchanges

The most common type of 1031 exchange, forward exchanges are used when an investor sells his or her relinquished property first, then acquires the replacement property while the intermediary holds the proceeds that will be used to invest in the new property.

Reverse exchanges

A reverse exchange is used when someone has lined up a replacement property, but has been unable to sell the intended relinquished property. Sometimes called a Parking Transaction, it helps solve the frequent problem of timing the purchase of new property after the sale of the old property.

Improvement exchanges

This is a type of reverse exchange. In this case an intermediary acquires a parcel of property, obtains financing for improvements, and later transfers the improved property as replacement property for an in-kind exchange.

“We recently completed an improvement exchange,” said Gelson. “A client that sells power equipment outgrew their headquarters and had a buyer for it. They also had a piece of land under agreement where they wanted to build their new headquarters. We had the proceeds from the sale placed into escrow and over a period of six months used that money to build and improve the new facility and they were able to defer the gains on the sale of their property by utilizing a combined forward and improvement exchange.”

Pros and cons

The 1031 rule is not without controversy. There have been many attempts by Congress to repeal the code and one is currently pending. Critics say the rule allows people and institutions to unfairly put off paying their taxes and could be costing the government more than $4 billion a year in revenues, according to the congressional Joint Committee on Taxation. In addition, they say the relaxed rules on what constitute “like-kind” properties can lead to abuse.

But supporters say that view is shortsighted.

“When you think about it overall, you realize most of these transactions are being done by businesses that are growing and want to expand and hire more people and create more jobs,” said Scanio. “They might not go forward with them if the tax issue was looming over them.”

Moreover, the transactions themselves always involve a lot of people, Scanio said, like attorneys, appraisal firms, banks, and other third parties.

“So it provides for a good deal of commerce,” he said.

A lobbying group, the Real Estate Like-Kind Exchange Coalition, produced a study last year that found if Congress repealed the 1031 rules, real estate values would drop, the cost of capital would increase, inventory would be curtailed, rents would rise, and the economy overall would contract.

For now, IRS 1031 remains a powerful investment and planning tool, though it must be planned with care and professional advice.