A tax-free exchange involves the transfer of property between two parties, where the transaction is exempt from income taxation. This exemption is available for properties that are of the same type, even if they have differing quality levels. The exemption is limited to business and investment properties. A capital gains tax will eventually apply, at the point when the parties sell their properties without intending to reinvest in similar properties. The rules governing tax-free exchanges are stated in Section 1031 of the Internal Revenue Code.
As an example of a tax-free exchange, a tree farmer sells his farm, with the intent of using the proceeds to buy another tree farm. The tree farmer will only be assessed a tax if he later sells his new farm without intending to reinvest the proceeds in yet another tree farm.