Recently, I sold a 24-unit apartment complex in which I was going to owe around $100,000 in taxes—almost half of my profit to the government. Ouch. However, I paid them nothing from that sale, and instead I used that money to buy 70 more rental units. Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free And I did it all legally. I used an IRS rule known as a 1031 exchange. What Is a 1031 Exchange? Here I want to teach you all about the incredible—and sometimes risky—power of the 1031 exchange. You know as with any business venture, when you’re successful, Uncle Sam is there to collect his share. That rhymed—I didn’t even mean to do that. When it comes to selling a property that you own, chances are, like myself, you’re going to have significant taxes to deal with—especially if you follow the advice that you hear here on BiggerPockets and you bought an incredible deal and now you’re rolling in it. Now thankfully, if you’re paying taxes in the United States, our government provides the 1031 exchange as a way to defer those taxes to a later time—and possibly you can defer them forever. Keep in mind, this is only for rental property investments. Sorry, house flippers, it doesn’t work for you. All right. So, a fun way to look at the 1031 exchange is to think of Uncle Sam as a real uncle. Say for some reason you happen to owe your uncle some money when you sell a property. But Uncle comes over puts his big arm around you and says, “Listen here, you did such an awesome job with that real estate deal. I’m proud of you. And look, I know you owe me a bunch of money. But listen, champ, because you did such a super good job, I want you to keep the money you owe me and instead go put that into another deal.” Related: The 1031 Exchange Ultimate Guide for Real Estate Investors I mean, really! It’s like, “I’ll just invest with you on that. You’ll have more money to use for that next deal, so you can buy an even bigger deal. And then I’ll grow my wealth, and you’ll grow your wealth, and we’ll just settle up later in life. We’ll kind of be like partners. What do you say?” Pretty nice uncle, right? What Are the Rules of a 1031 Exchange? But here’s the catch. As soon as you agree, Uncle fires a gun in the air and says, “Go! You’ve got 45 days to find the perfect property. And then you’ve got six months to close on it, or the deal’s off.” That, my friends, is the 1031 exchange. Of course, there are a lot of rules that you’ve got to follow—like that 45-day rule (or really it’s 180 days to close on it), and you always want to be buying a more expensive property than what you just sold. The cool thing is though, if you do it correctly, you can reuse all that money that you would have paid toward capital gains tax, and now you can use it as funds for your next property. And even better, you can do it over and over and over again. Yes, someday you’re going to settle up with your uncle, and that tax bill could be huge at that point. But so will your wealth, because you just used all that money to build bigger and bigger wealth. In the meantime, you get to enjoy the cash flow from those properties. All of it. I mean you might pay some taxes on cash flow, but typically rental properties have so many deductions that you won’t pay much. If you hold these properties until you die, here’s the cool thing: the uncle forgives the entire debt that you owe. Then, your kids who inherit the property won’t have to pay a dime on that. Who ever said said the government’s not your friend?! But it’s not all daisies and sunshine. As I mentioned above, the government gives just 45 days to identify a “replacement property” to buy. So, if you’ve been investing in real estate for any length of time, you realize 45 days is not a lot of time to find a great deal—especially in a competitive market like we find ourselves in today. Clearly that law was written by people who didn’t invest in real estate. Like, “Oh, 45 days is plenty of time! How much work is it really to find something?” Related: Choose Wisely: 1031 Exchange or Opportunity Zone Investing? This can make the 45 days incredibly stressful and even cause investors to buy bad deals because of the tax alternative. I’ve been there and done that for this reason. Some investors choose not to actually use a 1031 exchange. Instead they just pay the government the tax, and they move on. Now alternatively, there are a few options you have. Let’s say you can’t find a deal in those 45 days. There are funds known as Delaware Statutory Trusts that you can put your 1031 money into, and it will combine it with a bunch other people to buy large (usually commercial) real estate. And that is a pretty passive way to get money though your return. It might not be quite as high as you could probably do on your own, but hey, it’s better than paying the government. So, the 1031 exchange can be a powerful tool for building wealth—but it’s not for everyone. Getting a firm understanding of how it works and how it might fit into your business plan is important for every real estate investor. Do you have any additional questions for me about 1031 exchanges? Leave them in the comment section below!