Taxpayers must generally report any profits made from the sale of a capital asset, and pay to the government any capital gains tax owed. But if a taxpayer is selling real estate, it's possible to defer capital gains by taking advantage of a tax break that allows you to swap investment property on a tax-deferred basis. Usually called a “1031 like-kind exchange” after Section 1031 of the Internal Revenue Code, this tax break applies to investment real estate and is designed for people who want to exchange properties of equal value.
If you sell property you own and then purchase other property (even in different states), as long as the values of the two properties are equal, nobody pays capital gains tax. That is true even if both properties have appreciated since they were originally purchased, and even if the investment properties are of different types. For example, you can swap an apartment building for a piece of undeveloped, raw land, or a second home that you rent out for a parking lot. There's no limit as to how many times you can use a Section 1031 exchange, but generally it is exclusive to real estate (with limited exceptions to personal property such as artwork).
Section 1031 like-kind exchanges are great opportunities to defer taxes, but they can be complicated and require advance planning. For example, you must identify your replacement property within 45 days of selling your currently owned real estate, and you must close on the new property within 180 days. There are other restrictions and pitfalls that need to be considered, so your first step is to contact an attorney or accountant if you're considering a Section 1031 exchange.
Note from author: thanks to Hodakowski & Hodakowski CPAs in Flemington, NJ for the inspiration for this entry!