“Tax-free” is a little misleading because it is really “tax-deferred.” You pay no income tax at the time of sale, but you do pay it eventually. The process is called a 1031 exchange. As long as you keep selling properties and quickly buying more, meeting all the requirements of section 1031 of the Internal Revenue Code, you can keep delaying your taxes.
In a nutshell, this is how it works. First you sell the first property. The IRS calls this the relinquished property. All the sale proceeds must be kept in escrow by someone called a qualified intermediary.
Usually, this is a closing attorney or escrow company. You have 45 days from the sale of the first property to identify the new piece of real estate you want to buy. The IRS calls the new property the replacement property. You identify the property in a writing you give to your qualified intermediary.
You can pick up to three properties to identify, but you must buy one of those properties within 180 days of the sale of the first property. If you do it exactly right, you do not pay any taxes this year on the sale of the first property.
The technical details regarding other requirements can get pretty complicated. For more information, you should read IRS Publication 544, “Sales and Other Dispositions of Assets,” and Form 8824, “Like Kind Exchanges,” available at www.irs.gov. If you do anything wrong in this process, you will have to pay taxes in the year of the sale. This is not an area for do-it-yourself work. Hire a tax professional to assist you.