Tax-Free Exchanges

A tax-free exchange of one investment/business real property for another is provided for by Section 1031 of the Internal Revenue Code. Simply stated, Section 1031 allows a property owner to sell the real property and reinvest the proceeds by purchasing "like-kind" real property. This transaction, when conducted properly, enables the property owner to defer capital gain taxes. The is the primary advantage of a tax-free exchange: the taxpayer may dispose of real property without incurring any immediate tax liability.

People often fail to consider a tax-free exchange as an investment strategy because they are misinformed about the legal requirements. Here are some of the common misconceptions:

Myth: The "like-kind" requirement limits the taxpayer's options.

Fact: Real property must be exchanged for "like-kind" property; however, "like-kind" simply means that real property must be exchanged for real property, and all real property is "like-kind." For example, a single-family residence may be exchanged for a motel; vacant land may be exchanged for an office building, etc.

Myth: In an exchange, title to the replacement property must be acquired at the same time the relinquished property is conveyed.

Fact: The properties exchanged by the taxpayer do not have to close at the same time. In most cases, the taxpayer has 180 days after closing on the relinquished property in which to purchase the replacement property.

Myth: Exchanges require two parties who want each others properties.

Fact: Two-party exchanges are possible but in reality such two party swaps rarely occur. An exchange is usually accomplished with the help of a qualified intermediary and usually involves four principal parties: the taxpayer, the buyer of the relinquished property, the seller of the replacement property, and the qualified intermediary. The parties often do not know each other and their properties may even be located in different states.