A 1031 exchange is a tool used by savvy real estate investors to help build wealth over time. The completion of a successful 1031 exchange requires a lot of knowledge and skill.

If you don't take the time to educate yourself on the ins and outs of this type of real estate transaction, you could find yourself in hot water with the IRS. Here's what you need to know about the rules of a 1031 exchange to use this type of transaction successfully in the future.

1. Know the Property's Purpose

The purpose of the properties in question can have a direct impact on their eligibility for a 1031 exchange. Primary residential properties are not eligible for inclusion in a 1031 exchange. Some vacation properties can also be excluded. Only properties that are going to be used for business or investment purposes qualify. A 1031 exchange is essentially a swap of one business or investment property for another.

2. Ensure Properties are Like-Kind

The main reason investors use 1031 exchanges in real estate is to defer any capital gains tax they might have to pay on the sale of an investment property. In order for capital gains taxes to be deferred in a real estate transaction, the IRS must deem both properties involved in a 1031 exchange as like-kind. This means that the properties must be comparable in size, value, and income potential.

3. There are no Quota Limitations

As long as you are engaged in the legal exchange of properties, there is no limit to the number of 1031 exchanges that you may complete during your lifetime. Having the ability to complete multiple exchanges will allow you to successfully defer any capital gains taxes as you buy and sell real estate. This tax deferment is what helps savvy investors accumulate wealth within the real estate market.

4. Some Exceptions Exist

Despite the fact that 1031 exchanges are not designed to include private residential properties, there are some exclusions that may allow you to add a residential property to your portfolio. In order to qualify for a 1031 exchange, the residential property must be used as a fair rental for a period of time. This rental period essentially transforms the property from a residential unit into an income-generating unit. Once the rental income has been established, you can legally include a residential property in future 1031 real estate exchange transactions.

For more information about a 1031 exchange, contact a local investment service.