Define 1031 Tax-Free Exchange:

"1031 tax-free exchange is defined, “as a provision in the United States Internal Revenue Code (Section 1031) that allows individuals or businesses to defer the payment of capital gains taxes when exchanging against certain types of investment or business properties.” 

Explain 1031 Tax-Free Exchange:

Under a 1031 exchange, if a taxpayer sells a property that qualifies for the exchange and uses the proceeds to acquire another property that is also considered like-kind, they can defer paying capital gains taxes that would normally be due upon the sale of the original property. The tax liability is postponed until a subsequent taxable sale occurs.

Here are some key features and requirements of a 1031 tax-free exchange:

1. Like - Kind Property: The properties involved in the exchange must be of the same nature or character, but they do not have to be identical. For example, an individual can exchange a residential rental property for another residential rental property or even a commercial property for another commercial property.
   
   
2. Qualified Intermediary: To facilitate the exchange, the taxpayer must use the services of a qualified intermediary (QI) or accommodator. The QI assists in the sale of the original property, holds the proceeds from the sale in a separate escrow account, and then uses those funds to acquire the replacement property on behalf of the taxpayer.
   
   
3. Identification and Timing: The taxpayer must identify potential replacement properties within 45 days of selling the original property. They must also complete the acquisition of the replacement property within 180 days or the due date of their tax return, whichever comes first.
   
   
4. Reinvestment Requirement: The value of the replacement property must be equal to or greater than the value of the original property to defer the entire capital gains tax liability. If the taxpayer receives cash or other non-like-kind property as part of the exchange, it may be subject to immediate taxation.
   
   
5. Personal Use Properties and Inventory: Certain types of properties, such as primary residences, second homes, and inventory held for sale, do not qualify for a 1031 exchange. The provision primarily applies to investment or business properties.

Example of 1031 Tax-Free Exchange

Let's consider an example of a 1031 tax-free exchange to illustrate how it works, along with some relevant numbers and provisions:

1. Original Property Sale: Property A is sold for $500,000. The adjusted basis (original purchase price minus depreciation) of Property A is $400,000.Therefore; the capital gain realized from the sale is $100,000 ($500,000 - $400,000).
   
   
2. Identification and Timing: Within 45 days of selling Property A, the taxpayer identifies three potential replacement properties: Property X, Property Y, and Property Z.
   
   
3. Replacement Property Acquisition: The taxpayer decides to acquire Property X for $600,000 as the replacement property. The total value of the replacement property exceeds the net sales price of the original property, ensuring full deferral of the capital gains tax.
   
   
4. Qualified Intermediary (QI): The taxpayer engages a qualified intermediary (QI) to facilitate the exchange. The QI holds the proceeds from the sale of Property A in a separate escrow account.
   
   
5. Tax Deferral: Since the taxpayer has complied with the requirements of a 1031 exchange, the $100,000 capital gain from the sale of Property A is deferred.

The taxpayer does not need to pay capital gains taxes on the proceeds at the time of the exchange.

It's important to note that the example provided simplifies the process for illustrative purposes. The actual implementation of a 1031 exchange involves several complex rules, timelines, and regulations that must be followed precisely to qualify for tax deferral.