In a typical real estate transaction, the property owner is taxed on any gain realized from the sale of property. However, under Internal Revenue Code, Section 1031(a).1, the tax on the gain is deferred until some future date.

Section 1031 provides that “no gain or loss is recognized if property held for productive use in a trade or business or for investment purposes is exchanged solely for property of a like-kind to be held either for productive use in a trade or business or for investment.” A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax (no taxable event). In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.