Unless a seller is selling his/her primary residence in which they have personally lived for two years or more, any “gain” on the sale (the price the home sales for, less the price the seller originally paid for the property plus the cost of any improvements, or “basis”) is subject to capital gains tax (15% for most individuals).
Section 1031 of the tax code provides an exception to the capital gains tax where “like kind” properties are exchanged. The definition of “like kind” properties is rather broad and usually most exchanges of real property will meet this definition. As such, a seller who is selling a property other than their primary residence and planning to use those proceeds to buy a new property can utilize section 1031, and prevent tax on the capital gain, provided they comport with the procedures and rules prescribed for under section 1031 and its regulations. (Note that technically speaking, the tax is not avoided, but deferred until the eventual sale of the property. Nonetheless, if the seller utilizes the 1031 exchange on any subsequent sale the tax will remain deferred.)
To illustrate: John Smith buys a vacation home at Ocean City, Maryland in 1990 for $100,000. John now wants to sell the vacation home for $200,000, in order to purchase a vacation home at Deep Creek Lake for $300,000. Ordinarily, John would be taxed on the $100,000 gain on the beach home at a rate of 15%, or $15,000. If John were to utilize and comply with section 1031, John could sell the beach home for $200,000, defer any capital gains tax, and use the full $100,000 gain as a down payment on the home at Deep Creek Lake.
While extraordinarily useful, the 1031 exchange is quite complex. As such it is highly recommended that anyone contemplating utilizing the 1031 exchange consults a REALTOR®, such as myself, knowledgeable and experienced in tax law and its effect on the real estate transaction.