Typically a property owner is taxed on any gain realized from the sale of investment property. Internal Revenue Code §1031 provides an opportunity for the property owner to defer the tax on the capital gain until some future date.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held 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 Section 1031 Exchange allows 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. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. rental property exchanged for a strip mall). Therefore, the taxpayer should not be forced 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.