Ace the Arizona Real Estate Exam 2026 – Unlock Your Property Dreams!

The rationale for why the correct answer is that Phillip will have to pay capital gains taxes when he sells the apartment building, assuming he does not exchange it for another property, lies in the mechanics of a 1031 Exchange. A 1031 Exchange allows an investor to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into another like-kind property.

In this scenario, Phillip has successfully exchanged his office building for an apartment building, which means he has deferred the capital gains taxes that would have been incurred from the sale of the office building. However, this deferral is contingent upon him continuing to use the newly acquired property in a similar manner. If Phillip later sells the apartment building without engaging in another 1031 Exchange, he will then become liable for capital gains taxes on the appreciation in value that occurred from the sale of the office building and any further appreciation on the apartment building.

This mechanism is crucial in understanding how capital gains taxes work in the context of property exchanges. The gain is not eliminated but rather deferred, meaning that eventual sales without further exchanges trigger the capital gains tax obligation. Therefore, D accurately captures when Phillip would need to settle his capital gains tax liability.