[1] This kind of transaction is also called a "1031 exchange", because Internal Revenue Code section 1031 of the U.S. Internal Revenue Code allows owners of certain kinds of assets to defer capital gains taxes on any exchange of like-kind properties.
The transaction has to be properly structured, including that the taxpayer cannot be deemed to have actually or constructively received the sales price of the relinquished property.
The idea behind this section of the tax code is that when an individual or a business sells a property to buy another, no economic gain has been achieved.
According to section 1001(c) of the Internal Revenue Code, all realized gains and losses must be recognized "except as otherwise provided in this subtitle".
A like-kind exchange is one of the qualified exceptions, serving as the proto-typical "non-recognition provision".
Treasury Regulation § 1.1031(a)-1(b) offers a little guidance, suggesting that the term "like kind" refers to "the nature of character of the property and not to its grade or quality".
Fortunately, a "ceiling rule" in section 1031 takes care of this problem by providing that gain or loss is recognized, but only to the extent of the amount of boot received.
Thus, upon a cash sale of the new property for its fair market value of $12,000, no gain or loss would result.
Property transferred in a like-kind exchange is often encumbered by liabilities and debt, especially where the asset is real estate.
In this regard, the tax code treats relief from indebtedness as additional cash boot in a like-kind exchange.
That means a like-kind exchange is bad news in the case of a realized loss.
Section 267(a) of the tax code disallows deductions for losses resulting from sales to related persons.
However, the basis of the property received by the taxpayer in a like-kind exchange with a relative is governed by section 1031.
The two parties may involve a third party willing to pay cash (perhaps because the new property has a value less than the old property's basis, or because the taxpayer's desire for cash exceeds the desire to minimize liability for federal income taxes).
Congress responded to this ruling by imposing time limits on the identification and receipt of replacement property.
Due to periodic changes to the tax code, as well as detailed regulations that contain a number of technical requirements, it is important to check the most current rules and regulations before proceeding with a like-kind exchange.