Major sales often come with major tax liabilities. Exchanges allow you to trade one asset for another while delaying (or, in some cases, averting) the associated tax bill. Two of the most important types of transfers are 1035 exchanges and 1031 exchanges.
But what is a 1035 exchange? It involves trading something like a life insurance policy or endowment for something similar. A 1031 exchange, on the other hand, involves selling one investment property and using the proceeds to buy a very similar property.
This article will explain how 1035 and 1031 exchanges work, so you can make smart decisions about your portfolio and investment future.
The Short Version: What Is a 1035 Exchange?
A 1035 exchange is a financial tool you can use to transfer an investment in a life insurance policy, endowment, or annuity into something similar. Under IRS Tax Code 1035, you’re not required to recognize a gain or loss on these types of exchanges.
Typically, you would be required to pay taxes on these transactions. For example, the IRS explains that life insurance proceeds are taxable if you are the policyholder, surrendered the policy for cash, and got more than the cost of the policy.
By using the 1035 exchange process, you can avoid a hefty tax bill when you’re ready to move on from a life insurance policy, endowment, or annuity that isn’t working for you.
Imagine this scenario. You’ve changed jobs recently, and your life insurance policy from your former employer is fully vested but can’t come with you. The new job comes with a better policy, but you don’t want to start investing all over again. With a 1035 exchange, you could shift to the new policy without a financial penalty.
The Short Version: What Is a 1031 Exchange?
A 1031 exchange is a financial tool you can use to transfer an investment in a business or investment property to a similar type of property. Under IRS Tax Code 1031, you’re not required to recognize a gain on an exchange like this.
Typically, when you sell an investment property, you’re required to pay associated capital gains on the sale. Depending on how long you’ve owned the property and how well it’s performed, that bill could be large enough to eat up the profits you hoped to use elsewhere.
With a 1031 exchange, you can sweep up that tax liability into a new investment. It must be similar to the old version (so you can’t use this tool to sell a rental home and buy your primary home, for example). However, it could be a smart tool to help you diversify your portfolio and trade out something that isn’t working for something with more potential.
While 1031 exchanges can save you money, the bill doesn’t disappear. If you sell the second property at some point down the line, you’ll be required to recognize the gain and pay the associated taxes. The only way to avoid this surprise is to keep ownership of the property until your death or keep exchanging it endlessly until your death.
As you might expect, 1031 exchanges can be complicated. Most people need to hire someone to help them meet all the deadlines, follow the rules, and smooth the transaction. The deadlines and rules aren’t flexible, so you need to make sure you are following the criteria precisely. However, your hard work could mean keeping your investment money circulating rather than paying the tax collector.
Similarities Between 1035 & 1031 Exchanges
Now that we’ve explained 1031 and 1035 exchanges, let’s examine what makes these financial tools so similar.
Naming Conventions
Both 1031 and 1035 exchanges get their names from the tax code. The numbers within the name refer to the specific rules within the tax code. They also involve the word exchange, as these are tools you’ll use to swap one thing for something very similar.
Potential Tax Benefits
Few people want to spend more money on taxes than is absolutely necessary. Exchanges allow you to reduce your potential tax burden, even as you make significant changes to your portfolio.
Both of these approaches involve transactions that would normally trigger taxes. Use them properly, and you won’t have to pay when the deal goes through.
Need for Similar Trades
Both 1031 and 1035 exchanges require participants to purchase something very similar to the item they’ve sold.
For example, 1035 exchanges involve financial tools like life insurance, endowments, and annuities. You can’t use these tools to purchase a different type of financial tool, such as a savings bond. The item you buy must be very similar to what you’ve sold.
A 1031 exchange is much the same. The two properties involved must be considered “like kind,” or things of the same nature, character, or class. You could use an exchange like this to sell one office building and buy a building of rental apartments. However, you couldn’t use this tool to sell your personal home to invest in an office building.
If you’re uncertain if the property you’re considering is “like kind,” talk to an expert. You want to ensure you are doing the process correctly to avoid a surprise tax bill.
Differences Between 1035 & 1031 Exchanges
While both forms of exchanges have the potential to save you money at tax time, important differences separate them, including the following:
What Can Be Exchanged
A 1035 exchange is designed for financial tools like annuities, life insurance, and long-term care insurance. You can use this tool to trade a similar product for another.
A 1031 exchange, on the other hand, is designed for transactions involving investment properties. You can trade something like an office building for another office building or a different type of investment property.
Deadlines
A 1035 exchange typically doesn’t involve a deadline. Instead, you’ll fill out a form with one organization and transfer the asset to another organization. As long as you don’t accept a check in the middle and do a simple transfer/exchange, there is no deadline requirement.
A 1031 exchange is very different. While you don’t have to complete the sale and purchase simultaneously, you must meet two very tight deadlines, or the proceeds will be taxable. First, you have 45 days from the date you sold one property to identify a replacement. Next, you must complete the sale and take possession of the new property no later than 180 days after the original sale.
Outside Help
While it’s always smart to consult with a financial planner before making decisions about assets like life insurance and annuities, you’re not required to hire someone to help you with a 1031 exchange. Typically, you’ll fill out a form (like this one) to wrap up the process.
A 1031 exchange is very different. If you handle this transaction alone, you’ll take receipt of the proceeds from the sale of the first property. At that point, the funds are taxable.
Hiring a qualified intermediary allows you to place the funds under guardianship and use them to buy something else. You’ve never touched the money directly, so it’s not taxed. You must hire someone to handle this step.
Fees and Taxes
A 1035 exchange involves swapping one financial product for another without paying associated taxes. If you follow the rules, the tax bill never appears. It’s simply wiped away.
A 1031 exchange, on the other hand, just defers your tax burden. You must calculate and track the basis of the property you bought in the exchange. When that property is sold, the original deferred gain and any more you’ve acquired is taxable.
Which Version Is Right for You?
If you’re hoping to diversify your real estate investment portfolio, a 1031 exchange is a smart option. Trade one property that isn’t performing for one that will, and ensure you don’t lose too much of your profits to a big tax bill.
At 1031 Pros, we’ve helped thousands of investors just like you handle these complicated transactions. We can work as your qualified intermediary, holding your funds securely until your next purchase. And we will ensure you stick to the schedule and don’t miss your deadlines.
Best of all, we will provide all the necessary documents, so you’ll be ready at tax time. We take the stress out of the process for you, ensuring your transaction is done correctly and well. Contact us to get started.
References
1.1035-1. Internal Revenue Service, Treasury.
Are the Life Insurance Proceeds I Received Taxable? (January 2024). Internal Revenue Service.
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
26 U.S. Code 1035: Certain Exchanges of Insurance Policies. Cornell Law School.
1035 Exchange Form. (January 2024). New York Life.
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