Have you made investments that make you question whether they were worth it? Market fluctuations and new financial or insurance products can be tempting because of promised upgrades and more favorable terms. If you’re looking to manage assets without losing your money to taxes, choosing between 1031 vs 1035 exchanges can be confusing. They may be smart ways to reinvest, but they serve different purposes.
This blog will demonstrate the differences between 1031 vs 1035 exchanges, benefits, and potential drawbacks. You can take charge and make an informed choice that best suits your financial strategy and investment goals when you understand them both.
What Is the Difference between a 1031 and a 1035 Exchange?
When deciding between 1031 vs 1035 exchanges, keep in mind they serve different needs. Both exchanges are used to transfer funds from one property to another.
The key difference is that a 1031 exchange applies to investment real estate properties or properties used for business. It allows the swap of one investment property for another without immediately paying capital gains taxes on the sale. You can simply reinvest your proceeds into new properties and keep more of your money working for you.
On the other hand, a 1035 exchange was designed for life insurance, annuities, and endowments. Unlike a 1031 exchange, which deals with real estate, a 1035 exchange is specific to insurance products. For example, you might want to exchange an outdated life insurance policy for a newer one with better benefits or even lower premiums. However, both allow you to make exchanges with like-kind properties to defer capital gain taxes, with some rules and exceptions.
1031 Exchanges Rules to Consider
If you’re looking strictly at investments and not insurance products, then the choice between a 1035 vs 1031 exchange is easy enough. However, you should still consult with a financial advisor to answer your questions. You still need to be mindful of the various 1031 exchange rules to take advantage of this strategy.
Only Like-Kind Exchanges are Allowed
For a 1031 exchange to work, the properties involved must be “like-kind.” This doesn’t mean they have to be identical; any real estate used for business or investment can be exchanged for another. For example, an investor can swap a single-family rental property for a multi-family unit, commercial property, or even raw land. You don’t need to swap land for land or an apartment building for an apartment building.
This flexibility helps investors adjust to market conditions, upgrade properties, or move into different real estate types. The main point is that both properties are held for investment or business purposes, not personal use. You can’t pursue an exchange with real estate for stocks, bonds, or personal property because of this 1031 exchange rule.
A Qualified Intermediary (QI) Is Required
A third-party qualified intermediary must handle the transaction to comply with IRS rules. Their role is to hold the sale proceeds and then transfer them to the purchase of the replacement property. Taking personal control of the money at any point would actually disqualify the exchange and trigger an immediate tax liability for you—keep this in mind. A QI helps ensure all steps follow the 1031 exchange rules, preventing you from costly mishaps along the way.
Strict Timelines are in Effect
After selling your original property, you have 45 days to identify potential replacement properties. This period is strict—day 46 is too late. You can identify up to three properties or more under certain conditions, but they must be on your list by the deadline.
You have 180 days to close on the new property from the date of your original property’s sale. This 180-day clock runs from the sale date, not from when you identify a replacement property. Even by a day, missing the deadlines for this 1031 exchange rule will disqualify the exchange, and you’ll owe taxes on the original sale.
Investments Must be of Equal or Greater Value
This 1031 exchange rule mandates that the replacement property must be of equal or greater value than the property sold. If you sell for $500,000, you need to invest the entire $500,000 into the new property. Taking any cash away from this transaction will trigger capital gains taxes on that amount. The aim of a 1031 exchange is to reinvest all the proceeds to keep deferring the tax.
What Is the 2 Year Rule for 1031 Exchange?
The 2-year 1031 exchange rule means you should hold your property for at least two years to show it’s an investment. There isn’t a strict law, but the IRS and tax advisors see two years as a safe timeframe. This period shows your intent to hold the property as an investment since it will appear on two tax returns and likely generate rental income or expenses.
The rule is based on IRS guidelines and court cases. For exchanges with related parties, like family members, the two-year hold is mandatory to prevent tax abuse. If you hold a property for less than two years, the IRS might not see it as a valid exchange, and you could face taxes. Holding for two years helps prove it’s a real investment and keeps you within IRS rules.
Pros and Cons of a 1031 Exchange
As with any tax strategy, there are some pros and cons of a 1031 exchange.
These are benefits of a 1031 exchange:
- One of the biggest 1031 exchange advantages is tax deferral. By reinvesting proceeds from a sale into a new property, investors can avoid immediate payment of capital gains taxes. This allows more capital to stay in the investment, increasing potential returns. However, deferral does not eliminate capital gains taxes.
- Another benefit is the ability to upgrade or diversify properties. Investors can trade older or underperforming properties for those with higher income potential or more desirable locations. This flexibility helps align investments with market opportunities and personal goals.
- A 1031 exchange also aids in estate planning. Properties exchanged multiple times can defer taxes indefinitely, and heirs may benefit from a stepped-up basis.
These are some drawbacks of a 1031 exchange
- Missing the deadlines can result in losing the tax benefits entirely.
- While the definition of like-kind is broad, it still limits investors to reinvesting in real estate. Cashing out or using proceeds for other investments without triggering taxes isn’t an option.
- The potential for future tax liability also looms. Deferred taxes don’t disappear; you will need to pay them eventually when the final property is sold without an exchange.
Financial Strategies Tailored to You
Work with our team to help you find the best investment and tax strategies to help you meet your financial goals. We look at the bigger picture while also paying attention to detail.
Plan your future with Asset Preservation!
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
A Roth conversion may not be suitable for your situation. The primary goal in converting retirement assets into a Roth IRA is to reduce the future tax liability on the distributions you take in retirement, or on the distributions of your beneficiaries. The information provided is to help you determine whether or not a Roth IRA conversion may be appropriate for your particular circumstances. Please review your retirement savings, tax, and legacy planning strategies with your legal/tax advisor to be sure a Roth IRA conversion fits into your planning strategies.
The commentary on this blog reflects the personal opinions, viewpoints and analyses of the author, Stewart Willis, providing such comments, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), an SEC registered investment adviser or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment, legal or tax advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Personal investment advice can only be rendered after the engagement of Foundations for services, execution of required documentation, including receipt of required disclosures. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Any statistical data or information obtained from or prepared by third party sources that Foundations deems reliable but in no way does Foundations guarantee the accuracy or completeness. Investments in securities involve the risk of loss. Any past performance is no guarantee of future results. Advisory services are only offered to clients or prospective clients where Foundations and its advisors are properly licensed or exempted. For more information, please go to https://adviserinfo.sec.gov and search by our firm name or by our CRD # 175083.
