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BACKGROUND OF TAX FREE EXCHANGES
A tax free exchange is the taking advantage of §1031 of the Internal Revenue Code ("IRC") to defer the payment of income taxes. §1031 provides that "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or 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 or business or for investment."
Provisions regarding tax free exchanges have been in the IRC since 1924, eleven years after the first income tax law was first enacted. The rationale for its existence is that the taxpayer, by obtaining a like kind asset has;
(1) not really changed its position, and;
(2) usually does not have any money with which to pay the income tax that would otherwise be due.
The deferral of tax in a like kind exchange is currently codified in Internal Revenue Code section 1031.
Taxpayers have been utilizing this provision for years without
necessarily realizing it. A simple example solidifies the reason for the provision as well its application:
A business buys a truck in 1993 at a cost of $15,000 that it uses in its operation. After five (5) years the business has fully depreciated the truck's book value to zero while it has an actual value of $5,000. The truck is somewhat run down and the business needs a new vehicle. The taxpayer goes to the truck dealer to buy a new truck for $22,000 and trades in the old
truck for its value of $5,000, paying $17,000 for the new truck.
This is a classic exchange. The $5,000 gain ($5,000 in value less the basis of 0) is not currently taxable. The basis of the new truck (cost of $22,000) is reduced by the deferred gain of $5,000. As such, the taxpayer will begin to depreciate the new vehicle from its adjusted basis of $17,000.
The provisions of IRC §1031 is not limited to trucks. It is applicable to almost all property, real or personal, used in a trade or business or held for investment. Among the property excluded is property which is personal in use such as one's residence or inventory items used in a trade or business.
A taxpayer that owns a three family house that is held for investment can exchange that property for an office building. The business that has outgrown its current facility can defer the taxable gain by exchanging it for a new facility.
Today, the use of IRC §1031 is growing in popularity. According to the most recent statistics provided by the Internal Revenue Service, in 1998 more that 100,000 §1031 exchanges were done and year by year the volume has steadily been increasing.
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