Tax-Free or Tax-Deferred? What Does a 1031 Exchange Offer?

There are many myths circulating about the power of section #1031 of the US Tax Code. One of the biggest ones involves tax liability. Many inexperienced investors often refer to an exchange as “tax-free.” And, while that would be great if true, it is not. (Well, there is one exception, discussed below.)

When it comes to taxes and a 1031 exchange, the most important thing to understand is that an exchange is a deferral strategy not a tax avoidance scheme. You can use a 1031 exchange to trade business or investment property for other “like kind” property. When you do, you can avoid any immediate capital gains tax liability, so long as you meet the strict IRS rules governing all aspects of the 1031 transactions.

However, at some point in time tax will be due. When you sell your business or investment property outright, rather than trading it for another like-kind property, the taxman will be knocking at your door. This is a guarantee.

But there is one exception.

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 receive a step-up in basis to the fair market value of the property, calculated as of the date of death.

Of course, dying is a pretty extreme way to get out of capital gains taxes altogether. But if total tax avoidance with 1031 exchanges is your goal, that’s the only way to do it.

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If a 1031 exchange is in your future, visit our website to learn more about these powerful tax deferral tools and our qualified intermediary and replacement property locator services.