A 1031 exchange is a great vehicle for deferring gains on the sale of a property. The tax bill can be quite burdensome if the property being sold has appreciated markedly. Investors can potentially get around this problem by utilizing a 1031 exchange, pushing their taxes due on the gain out into the future.
But at some point, does the tax man come knocking? Or can you just keep executing a 1031 exchange forever?
An investor who executes a 1031 exchange and retains the replacement property indefinitely (i.e., until death) will never have to pay taxes on the relinquished property. This is different from what’s being asked in the article title, of course.
Let’s say the same investor wants to execute their second 1031 exchange. What will happen to the gain in this case? The original deferred gain continues to be deferred. Any new gain resulting from the second 1031 exchange is also deferred. So, the investor is still in good shape regarding deferring taxes on the two relinquished properties (from both exchanges).
If the investor executes a third 1031 exchange and then just continues executing a 1031 exchange, the mechanics are the same as in the previous example. Capital gain taxes will also continue being deferred into the future.
If the investor never sells their replacement property, they will not owe any taxes through these exchanges. Only when the replacement property is sold outright will they owe taxes.
Heirs receive a stepped up basis on inherited property. This means when property is inherited, its basis is marked to the market value at the time of inheritance. Because the property’s basis is the same as the market value, there are no gains and, thus, no taxes.
If an heir decides to 1031 exchange the inherited property (i.e., the relinquished property), they can. Additionally, the heir can continue deferring gains through a 1031 exchange, starting the chain all over.
There are many moving parts to successfully completing a 1031 exchange. It isn’t so much that the process is complicated but more that it is very tedious. The IRS imposes deadlines and strict rules that must be followed throughout the 1031 exchange process. A misstep at any point can disqualify the 1031 exchange.
Once you’ve completed a 1031 exchange, you’ve successfully jumped through all the hoops and have a batting average of 100%. But that’s only one at-bat. Of course, the more times you go up to bat, the more your chance of missing. And so it goes with potential missteps in 1031 exchanges.
The more times you execute a 1031 exchange, the more chances for something to go wrong. Being very diligent will certainly weigh in your favor, but there is always the possibility that something could fall out of line. However, even if that happens, with a good team (i.e., realtor, QI, attorney), you may still be able to salvage the 1031.