Can an owner really dispose of one property and acquire one or more replacement properties (thereby increasing his investment portfolio and potential profits) without paying taxes? Does the tax-free exchange seem like a tax gimmick? Why would the IRS allow an investor to dispose of a profitable investment property without extracting its share of the profit?

The key to understanding the rationalization for the tax-deferred exchange lies in focusing upon the equity rather than the property. Theoretically, the equity remains intact through the process of a trade. It moves its location from one property to another but remains undisturbed.

The tax law requires that taxes be paid on any realized gain upon the disposition of a property. However, the IRC (Internal Revenue Code) recognizes, and properly so, that in a trade of properties when an investor does not realize a gain he should not be taxed. Of course, to the extent that an investor removes funds from the exchange so that the equity in the acquired property is reduced from that of the disposed property, the transaction should be, and is, partially taxed.

The key phrase to remember is that, "No gain or loss shall be recognized on the exchange of property held for productive use in a trade of business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade of business or for investment." (IRC 1031 [a] [1])

Central to this definition is the phrase "like kind". It is important to recognize that "like kind" has nothing whatsoever to do with the property's use, but rather with its character. For instance, an apartment building need not be exchanged for another apartment building. In fact, it need not even be exchanged for improved properly. It can be exchanged for undeveloped property such as a commercial lot or a farm, or it could be exchanged for a shopping center or a warehouse. In fact, it has been held by the IRS that a lease of 30 or more years in duration may be exchanged; that water rights (if considered real property by state law) may be exchanged; that an undivided interest in mineral rights may be exchanged. All of the above may be exchanged under section 1031 of the IRC for real property which is either unimproved (such as a ranch, or vacant, city lot, or a mountain recreational site) or improved (such as a retail center, a rental house, or an office building).

My attorney would hasten to have me add that I am neither an attorney nor a CPA and that this article is not intended to give legal or tax advice and that no legal or tax decision should be made by a reader of this article based upon its content, but rather a reader must rely only upon the advice of his own legal and/or tax advisors. This is not merely a disclaimer; it's good advice. My intent is merely to awaken the uninitiated to the awareness that the Section 1031 tax deferred exchange may be, and commonly is, used as an estate-planning vehicle of merit and substance.

Having so said, let me mention the five basic tests that a trade must pass to qualify as being a "tax-free" or tax deferred exchange.

First, both properties, the one disposed of and the one acquired, must be business or investment property. This eliminates the possibility of exchanging your investment condo by the lake for a home you will occupy in the city.

Second, both parties must give and receive like property. That is to say, to the extent one person gives real property and receives real property and personal property, the exchange will be taxed to the extent of the personal property received.

Third, the "identification period" must be satisfied. Within 45 days of closing on the relinquished property, the exchangers must identify which property or properties they are going to acquire. The rules for identification of this property are clearly set forth in the Internal Revenue Code.

Fourth, practically speaking, the entire transaction must be concluded within 180 days from the date of closing on the relinquished property.

Fifth, the property may not be "dealer" property. This is to say that neither property may be held for re-sale to others but must be held for investment.

This is by no means a complete expose on the benefits of a tax-deferred exchange. The intended moral of this article is simply this: The IRS has established guidelines that an investor may use to dispose of one property and acquire another without the requirement to pay taxes on his gain. This "IRS tax-free loan", as it is often called, is, when appropriate, an excellent vehicle for building an estate. Its use can dramatically increase an investor's portfolio and profits. - MH