Advantages of Tax-Deferred Exchanges

 The tax literature and popular press point to several motivations for use of Section

1031 exchanges. First, exchanges serve as an effective shelter from taxes, thereby

preserving investment capital. In addition, exchanges can be used to upgrade portfolios

(Fickes, 2003). By deferring taxes, the taxpayer can also leverage appreciation and afford

to acquire a larger/higher priced replacement property. Section 1031 exchanges can also

be used to consolidate or diversify properties, exchange low-return properties for high-

return properties, or to substitute depreciable property for non-depreciable property

(Wayner, 2005a and 2005b).

Drawbacks of Tax-Deferred Exchanges

 Despite the advantages of tax-deferral, Section 1031 exchanges have several

drawbacks. First, the taxpayer's basis in the replacement property is set equal to the

market value of the replacement property, minus the deferred gain. Thus, the larger the

amount of tax-deferral, the smaller is the depreciable basis in the replacement property

and, therefore, the smaller is the allowable deduction for depreciation. Moreover, the

larger the amount of tax-deferral, the larger will be the realized gain if and when the

replacement property is subsequently disposed of in a fully taxable sale.

 A second disadvantage is that the transaction costs (both monetary and non-

monetary) associated with initiating and completing the exchange will likely exceed the

costs of a fully taxable sale. The additional costs may include settlement fees,

intermediary fees, and attorney preparation fees (Wayner, 2005b). These first two

disadvantages are explicitly considered in the conceptual model presented in Chapter 4.

 An additional disadvantage is that Section 1031 exchanges do not allow for the

recognition of a loss for tax purposes. Thus, taxpayers will avoid using exchanges if they