Are 1031 exchanges really "tax-free" exchanges?
No. The idea behind a 1031 exchange is that a property owner can sell a piece of investment property and reinvest the sale proceeds into another investment property, and DEFER any tax due on the sale. Because the taxpayer invests all of the proceeds into a new property, he only realizes a "paper" gain. There are no funds available from the transaction to pay any tax. While the form of the taxpayer's investment has changed from the old property to a new one (perhaps a shopping center into an office condo), the IRS recognizes that no cash has been generated. Therefore, Sec. 1031 enables the taxpayer to carry the basis into the new property and even to repeat such transactions- allowing the gain to be deferred indefinitely.
In short, a 1031 exchange is not tax-free, but tax-deferred. At the time that the property is ultimately sold without exchanging into a new property, the gains- both original and any additional gain that the taxpayer realized since the purchase of the original replacement property- will be taxed. For investors planning on carrying investment property into their estates, it really becomes a "tax free" transaction because the the estate will receive a step-up in basis.