The Meaning of Indefinite Tax Deferral: When Do You Pay Tax After a 1031 Exchange?

The primary reason to conduct a 1031 exchange is that doing so provides access to indefinite tax deferral. Typically, when a taxpayer sells a property for more than its purchase price, the gain realized at the time of sale is subject to immediate federal income tax liability (this can either be ordinary income or capital gains tax, depending on how long the property was held). As a result, working with a 1031 exchange facilitator to meet the requirements for conducting a “like-kind” exchange can afford significant tax benefits, and conducting a 1031 exchange can be well worth it when both properties qualify.

But, this raises an important question: What is meant by “indefinite” tax deferral?

Understanding Indefinite Deferral Under Section 1031

While many aspects of conducting a 1031 exchange are complicated, the concept of indefinite tax deferral is surprisingly straightforward. In essence, it means exactly what it says: If a taxpayer qualifies to defer otherwise taxable gain through a 1031 exchange, there is no specified timeline for when (or if) the taxpayer will have to pay the IRS.

If the taxpayer never sells the replacement property, then the taxpayer’s tax liability will remain deferred in perpetuity. Likewise, if the taxpayer sells the replacement property in another 1031 exchange, the tax owed in connection with both exchanges will remain deferred. It is only when a taxpayer conducts a sale outside of a 1031 exchange that the obligation to pay deferred tax comes into play.

But, just like other tax liabilities, taxpayers can set off tax deferred under Section 1031 against taxable losses. Thus, taxpayers can (and often do) strategically time the sale of replacement properties to eliminate deferred tax liability without actually paying the IRS.

Taxpayers may be able to leverage other strategies to minimize (or eliminate) their tax liability as well.

As a result, taxpayers can make informed and strategic decisions about when (and if) to eventually recognize gain from a 1031 exchange. Taxpayers can make this assessment on a year-by-year basis—as long as they are able to sell their replacement properties in time to recognize the gain when it is advantageous to do so.

“Boot” Can Trigger Immediate Tax Liability in a 1031 Exchange

There is one critical exception to indefinite tax deferral under Section 1031: Even if a taxpayer generally qualifies for indefinite tax deferral through a 1031 exchange, the taxpayer may still owe tax on any “boot” received in connection with the sale of the taxpayer’s relinquished property.

This is where the “like-kind” element of a 1031 exchange comes into play. Under Section 1031, a taxpayer can only claim indefinite tax deferral in connection with the exchange of “like-kind” property. As a result, if a taxpayer receives any property in an exchange that is not of “like-kind” with the taxpayer’s relinquished property, this portion of the exchange is subject to immediate taxation.

While taxpayers should be careful to avoid inadvertently receiving boot in a 1031 exchange, receiving boot isn’t necessarily a bad thing in all cases. For example, taxpayers can offset tax on boot against losses recognized in the current tax year, and, in some cases, it may be desirable to obtain different forms of boot for different reasons. As with all aspects of conducting a 1031 exchange, an informed and strategic approach is critical, and this makes it essential to work closely with an experienced 1031 exchange facilitator throughout the process.

Documenting Eligibility for Indefinite Tax Deferral

When claiming indefinite tax deferral under Section 1031, it is important for taxpayers to be able to substantiate their claims to the IRS when necessary. As a result, it is imperative that taxpayers not only strictly comply with Section 1031’s requirements but also document their compliance every step of the way.

By working closely with an experienced 1031 exchange facilitator, taxpayers can navigate and document the 1031 exchange process with confidence. If you would like to know more about how to conduct a compliant 1031 exchange and leverage the tax benefits that are available, we are more than happy to walk you through what you need to know.

Schedule a Call with a 1031 Exchange Facilitator at 1031 National Services

To schedule a call with a 1031 exchange facilitator at 1031 National Services, call us at 888-872-1031 or request a free initial consultation online. We will arrange a time for you to speak with one of our experienced professionals in confidence as soon as possible.