The most common tax deferral strategies in use today utilize treasury regulations that were first implemented with the passage of Internal Revenue Code 1031 (IRC 1031) in 1921. This legislation had two primary objectives which remain relevant today: 1) To avoid unfair taxation of theoretical gains/losses in real property, and 2) To encourage active reinvestment of proceeds in domestic real estate and thereby helping strengthen and stabilize property values.
With respect to unfair taxation, Congress recognized that:
". . . if a taxpayer's money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit. The calculation of the profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a fair market value".
In other words, Congress recognized that it was fundamentally unfair to force an investor to pay taxes on a paper gain where the funds were still a part of an ongoing investment in similar types of income producing real estate assets. The intent of this objective was to encourage real estate investors to keep their funds tied up in successive properties to avoid taxes if they did not cash out and take possession of their deferred gains. So, starting often with single family income property, real estate investors are free to trade gains upon sale into a duplex, then a small apartment, and possibly later into a shopping center – without paying any taxes if all gains are reinvested. Taxes only become due when assets are soldand the investor chooses to take control of the funds rather than reinvest them in another property.
The second objective which remains very relevant today is to encourage greater investment in the US versus redeploying funds overseas. Through providing incentives to invest in US real estate, property values will tend to increase leading to increased taxes which will be realized from rising property incomes (versus gains which are deferred). Investors who sell US assets lose their tax deferral status if those funds are reinvested in foreign real estate.