“TAX-FREE” VS. “TAX-DEFERRED”

Exchanges under Section 1031 are “tax-deferred”, not “tax-free”, because the gain deferred in the transaction will be recognized on the ultimate sale of the replacement property received in the exchange.  The basis of the property sold in the exchange will transfer to the replacement property purchased, thus “rolling” the gain within the transaction.  This deferral is not limited to one transaction, and the taxpayer may continue to exchange properties so long as she increases the value of the replacement property received each time.  If the taxpayer ever sells outright replacement property originally received in an exchange, then gain will be calculated and taxes paid on the sale based on the lower carryover basis from the relinquished property plus the value of any new equity injected or debt incurred in the purchase of such property.

EXAMPLE:
Relinquished Property:                    Replacement Property:
FMV:    $400,000                             FMV:    $500,000
A/B:      $100,000                             A/B:      $200,000
Taxable Gain                   $300,000                                                           ($100,000 Carryover A/B)
Deferred                                                                                     _______  ($100,000 New Equity)
Potential Taxable    $300,000
Gain in Property

Under certain circumstances, the tax on the gain may never be realized.  One such instance occurs if the replacement property is held by an individual taxpayer until death.  If her estate is properly structured and does not exceed certain limitations, a full “step-up” in basis can be achieved without any tax being due on the property.