California Real Estate Practice Exam

SHE owns a single-family residence, and HE owns a rental property. If both intend to use their newly acquired properties for rental income after a trade, which statement is true?

1. Both parties can negotiate tax-free exchanges.

2. HE can negotiate a tax-free (deferred) exchange.

3. Neither can negotiate a tax-free exchange.

4. SHE can negotiate a tax-free (deferred) exchange.

The correct answer is: Both parties can negotiate tax-free exchanges.

In this scenario, the concept of a tax-free or deferred exchange hinges on the nature of the properties involved and the intent behind the exchange. When dealing with real estate transactions, Section 1031 of the Internal Revenue Code allows for the deferral of capital gains taxes on the exchange of like-kind properties, provided they are used for investment or business purposes. In this case, since both parties intend to use their newly acquired properties for rental income, it establishes their intent to use the properties as investment assets. This is crucial because it means that both single-family residences (if held for rental purposes) and rental properties can qualify as like-kind properties for the purpose of a 1031 exchange. Therefore, both SHE and HE can potentially negotiate tax-free exchanges based on the intended use of the properties as investment rentals. Recognizing that SHE's single-family residence can be treated as an investment property, primarily when held for rental income, supports the concept that both parties can engage in tax-free exchanges. This makes the statement about both parties negotiating tax-free exchanges valid within the context of the provided scenario.