What is deferred in a deferred exchange is the capital gains tax on the transaction. This is allowed under Section 1031 of the Internal Revenue Code in cases when someone sells a property to another party for the purpose of buying a "replacement property" from a third party. The logic is that if the applicant has not yet profited from the first sale, it is reasonable to limit tax exposure.
There are, however, rules to follow. One is that the purchase price of the replacement property must be at least that of the first sale item. In other words, someone who sold a factory and then used part of the money to buy a townhouse would not be protected under Section 1031. All of the proceeds from the first sale must go toward the second. A deferred exchange is sometimes referred to as a "Starker Exchange," from the name of the taxpayer who was first granted the right to conduct a deferred exchange by the U.S. Court of Appeals.
Another 1031 requirement is that the property be of "like kind." This relates not to the physical structures involved, but more to the purpose of the transaction -- rental property for rental property, commercial property for commercial property. The party doing the exchanging in a deferred exchange has a maximum of 180 days from the time of sale to acquire the replacement property, unless the next tax return due date pops up first.
A deferred exchange is always conducted through an "accommodator" who must be unrelated to the seller. This person or entity takes control of the proceeds from the first sale and then releases it to the seller of the replacement property. This is to ensure that the rules of a 1031 transaction are met. One advantage to the seller is that the accommodator can keep the funds in an interest-bearing account until the time comes to transfer them.
One exception to the deferred exchange rule requiring co-equal properties is if the buyer of the replacement property pays less for it, but pledges to use the leftover money to make improvements to that property. A capital gains bill will ultimately come due in a deferred exchange transaction, but this is a way of postponing the inevitable.
