1031 Exchanges: Tax-Free or Tax-Deferred?

Investors who are inexperienced with 1031 exchanges often erroneously refer to these transactions as “tax-free.” Yet this is incorrect, with one exception (discussed in a minute).

A 1031 exchange actually is a tax deferral strategy rather than a tax avoidance strategy. If you own business or investment property and you wish to trade it for another “like kind” property, you can use an exchange to do so and avoid incurring any immediate income tax liability on the transactions, so long as certain conditions are met.

And as there are no limits on the number of 1031 exchanges you can do, theoretically you could keep trading property indefinitely and continue to defer taxes along the way. However, when you eventually sell the property and do not replace it with something else “like kind” then your tax liability on any gain will finally come due.

There is one important exception, which can create a tax-free environment for 1031 exchanges. If you hold investment property until your death, any unrecognized gain usually escapes the grasp of the IRS forever. This happens because your heir will generally receive a step-up in basis to the fair market value of the property and this will be calculated as of the date of death.

However absent the death of the investor, any 1031 exchange is merely a tax-deferral device rather than a tax-free transaction.

To learn more about 1031 exchanges or our qualified intermediary and replacement property locator services, please visit our website.