You may exchange investment or business property for “like-kind” property without incurring a tax in the year of exchange if you meet the rules detailed in this chapter. Gain may be taxed upon a later disposition of the replacement property because the basis of the replacement property is usually the same as the basis of the property surrendered in the exchange. Thus, if you exchange property with a tax basis of $10,000 for property worth $50,000, the basis of the property received in exchange is fixed at $10,000, even though its fair market value is $50,000. The gain of $40,000 ($50,000 – $10,000), which is not taxed at the time of the exchange, is technically called “unrecognized gain.” If you later sell the property for $50,000, you will realize a taxable gain of $40,000 ($50,000 – $10,000).
Where property received in a tax-free exchange is held until death, the unrecognized gain escapes income tax forever because basis of the property in the hands of an heir is generally the value of the property at the date of death. If the exchange involves the transfer of boot, such as cash or other property, gain on the exchange is taxable to the extent of the value of boot.
You may not make a tax-free exchange of U.S. real estate for foreign real estate.
Tax-free exchanges between related parties may become taxable if either party disposes of the exchanged property within a two-year period.