A tax deferred exchange of investment property, often referred to as a "§1031" (the Internal Revenue Code section which defines an exchange) is most often chosen as a disposition / acquisition vehicle because, as its name implies, through its use it is possible to trade one property for another and defer any resulting capital gains taxes until a later date. This tax treatment allows an owner to invest the money he would have lost to capital gains taxes so he can purchase additional investment property thereby earning profit on a taxed but unpaid capital gain.
Critics have often referred to this as an interest free loan by the government to real estate investors.
Yes, this is a curious twist of logic based on the premise that wealth is inherently the government's and not the individual's, but it does illustrate the value of this disposition technique.

As an example, in the last exchange I consummated, a brother and sister owned an apartment building which sold for approximately $1,500,000. The sister had a two-thirds interest and the brother one-third. (The building had been left to them by their mother in a trust. Three weeks prior to her death her son made her mad. As a result, she immediately changed her will from an equal split to this uneven distribution ... an expensive lesson in timing.).

Upon disposition we divided their trusts so that each sibling could take their own investment path. The sister opted to exchange into two triple-net investment properties (one in Alabama, the other in Texas) in addition to a vacation condo in Keystone. The brother traded into a triple-net investment in Mississippi and an industrial lot and rental house, both in Nevada. The exchange was interesting from several points of view. It involved properties in six states. The exchange was from one property into multiple properties.

The ownership changed from one trust to two trusts plus a percentage of personal ownership. The acquisitions included cash purchases, some institutional financing, and some sophisticated third party financial techniques.

The exchange began with an apartment building and resulted in the ownership of commercial income properties, industrial land, residential rental housing, vacation rental housing, and triple net leases. The owners increased their cash flow, reduced their risk by diversifying their investment both geographically and by property type, and secured income stability through the restructuring into triple-net leases. While the sister satisfied a personal dream by acquiring a vacation property which, in addition to providing rental income, her family could use upon occasion, her rother added some speculative investment potential through the acquisition of land poised for development.

The §1031 exchange vehicle allowed this sister and brother to further their investment and personal goals without incurring a taxable event. This tax referral is the obvious magnet that draws most people to exchange. However, there are other attractions, not the least of which is tax planning for transferring wealth to heirs. This is possible because upon the owner's death the tax basis for the exchange property is increased to its current value. This can be, and most often is, a tremendous savings to the estate as the capital gains taxes are forever forgiven.

Often sellers become exchangers because market conditions dictate that there is a scarcity of available cash buyers. The exchange medium simply provides another financial culture, another financial tool, to accomplish financial goals. Also, a shortage of cash in the market often requires that a seller accept "terms" to attract a buyer. This can result in a seller's equity being frozen in secondary paper and leave him with less cash than he needs to accomplish his goals.

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