A tax-free exchange is a method of selling a capital asset, like real estate, according to certain prescribed rules and procedures in such a manner that all or most of the capital gains taxes will be deferred to the future. It may help to think that the taxpayer is not selling a capital asset but is reorganizing his or her investments. Congress decided this reorganization was not a taxable event if conducted in accordance with certain rules.
History and Evolution of the Tax-Free Exchange
Anyone familiar with tax-free exchanges of 20 or more years ago is amazed at the number and simplicity of exchanges being performed today. The history of tax-free exchanges dates back to the 1920s.
1921–1928: The first tax-free exchanges were executed. (This is not a new concept: It has just improved over time.) These exchanges involved two parties who traded/swapped properties.
1954: Congress passed Section 1031 of the Internal Revenue Code, giving the name to 1031. This was a rewrite or codification/reorganization of all the laws affecting exchanges, including court decisions on this subject.
The pertinent wording of the law follows:
“No gain or loss shall be recognized [in other words, no taxes have to be paid and no losses can be taken at the time of the exchange] on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” — Section 1031 Internal Revenue Code
Why Would a Client Want to Exchange?
The following is a list of possible reasons why your client may want to exchange:
- The client is determined to sell for some or any reason (age of neighborhood or maintenance expenses or whatever).
- The client is tired of residential rentals and wants commercial or vacant land.
- The client wants to switch into faster-appreciating investments.
- The client wants to get rid of appreciated non-income-producing vacant land and buy income-producing investments.
- Federal and state capital gain taxes can exceed 22 percent on the capital gain.
- The client sells fully depreciated property and buys a more valuable property, thus creating a new tax shelter.
- The client wants to leverage up his or her investments.
- The client wants to defer payment of tax liability to take advantage of the “time value of money.”
- The client wants to rearrange his or her holdings in anticipation of death.
- The client mistakenly thinks that selling is the only way to secure much needed cash.
- The client wants his or her investment property to be near his or her principal residence.
On What Properties are 1031 Tax-Free Exchanges Allowed?
Tax-free exchanges “are” allowed by the IRS on:
- Property held for the productive use in trade or business.
- Investment property
Tax-free exchanges “are not” allowed by the IRS on:
- Personal residences, second homes, and time-shares purchased for personal use.
- Inventory property (property held primarily for sale).
