First, a clarification: A tax-deferred exchange does not have to mean an actual exchange of properties. You do not have to locate another property owner willing to exchange properties with you in order to make an "exchange". It could involve the outright purchase of a property, which is then used in the exchange process. The IRS requires careful compliance to avoid having the exchange treated as a sale instead of a Section 1031 exchange, but other then proper structuring and documentation, a Section 1031 exchange may be no different from any other transaction.

How it Works

Briefly, Section 1031 of the federal tax code provides investment property owners with a means to dispose of one real property asset in exchange for another without having to pay taxes in the year of the exchange. The tax obligation is not vanquished, it will have to be paid someday, but Section 1031 permits the taxpayer to defer federal tax until an actual sale of the property occurs.

The benefit to you as a real estate investor should be obvious. By pushing the payment of taxes into the future with the exchange, you have the full value of the property available to be exchanged, and from a time value of money stand point, the longer your tax payments can be deferred into the future, the greater the present value of that deferral. These are complex, however, and as the disclaimer goes, should not be attempted without expert supervision.

First, the property must qualify for a Section 1031 tax-deferred exchange. The asset must be held for the production of income in a trade or business or held as investment property. Property held as a personal residence and property held as inventory are excluded.

Secondly, a tax-deferred exchange involves numbers of requirements that must be met to be eligible for exchange treatment. Namely, only like-kind properties must be exchanged. For example, whereas an apartment building for a parcel of raw land would qualify, a vacant lot for an automobile would not qualify. Moreover, only domestic (not foreign) like-kind properties must be exchanged.

Thirdly, the transfer of one property must be dependent upon receiving a qualified property in return within allotted time. The IRS currently allows 45 days for an acceptable exchange property to be identified and up to 180 days from the initial transfer to complete the delayed exchange.

Fourthly, exchanges involving boot (non like-kind property) require calculations that are even more complex. For example, if you receive a property with a smaller mortgage then the one you are disposing of, that results in net debt relief and is taxable as boot in the transaction. Properties not of equal value would constitute additional boot.