There are two basic types of 1031 exchanges: forward exchanges and reverse exchanges. In a forward exchange, the exchangor closes on disposition of their old property (aka the relinquished property) before they acquire their new replacement property. Forward exchanges are possible with nearly every type of like-kind property.
Here is a quick example of a common forward exchange to illustrate the definition. Imagine a property investor sells an apartment complex that they own, and intends to buy another larger apartment building in a different part of town. If the investor closes on the sale of his old apartment complex before purchasing the new apartment building, this is a forward exchange.
In this example, the investor can utilize a 1031 exchange to re-invest his money from the old real estate into the new one, and defer taxes on the capital gains. But in order to do so, a qualified intermediary must be involved to insulate the investor from receiving any capital gain in the eyes of the IRS. The replacement property (the new apartment building) must also be acquired within 180 days after the sale of the old property. Also, the new replacement properties must be designated or identified in writing within 45 days after the date of the closing of the old property.
Why would the United States government allow an investor to defer their taxes in a 1031 exchange, you might ask? Put simply, 1031 exchanges stimulate the economy. We don’t want to discourage and penalize investors for moving their capital around between like-kind investments. This allows capital to move efficiently to the most advantageous investments, creating jobs and stimulating growth. So long as investors are not cashing-out why should they be forced to pay taxes if they are only moving their existing equity around from one like-kind investment to another?