What Is a 1037 Exchange for U.S. Government Bonds?

A 1037 exchange is a provision in the U.S. tax code that permits the tax-free exchange of certain U.S. government bonds. This mechanism allows an investor to swap one qualifying bond for another without recognizing a gain or loss for tax purposes at the time of the transaction.

Qualifying U.S. Treasury Obligations

The provision applies exclusively to obligations of the United States issued under the Second Liberty Bond Act. For an exchange to qualify, both the bond being surrendered and the bond being received must be U.S. Treasury obligations issued under this authority.

While the tax code allows for such swaps, the U.S. Treasury has not offered tax-free exchanges for marketable securities, such as Treasury Bonds (T-Bonds) and Treasury Notes (T-Notes), in many years. This practice is not a current tool used for managing marketable debt.

In modern practice, this tax provision is most commonly applied to U.S. Savings Bonds. The rules allow for the exchange of one series of savings bond for another or for matured savings bond proceeds to be used to purchase other Treasury securities without triggering an immediate taxable event.

Tax Consequences of the Exchange

The primary tax feature of a 1037 exchange is the non-recognition of gain or loss. When an investor swaps an eligible bond for another, any accrued gain is not taxed at that moment. Instead, the tax obligation is deferred until the new bond is sold, redeemed, or matures.

A “substituted basis” rule is applied, meaning the tax basis of the original bond transfers to the new bond. For example, if an investor purchased a bond for $980 and exchanged it, the basis for the new bond is also $980, regardless of its market value when the swap occurs. This ensures the original gain is preserved within the new security.

The holding period of the original bond is also “tacked on” to the holding period of the new bond. If the investor held the first bond for three years, those three years are added to the holding period of the second bond. This determines whether a future gain or loss is classified as short-term or long-term. If any cash is received in the exchange, that portion may be subject to tax.

Executing and Reporting the Exchange

For U.S. Savings Bonds, exchanges are handled through the TreasuryDirect system. If the Treasury were to offer an exchange for marketable securities, it would issue a public announcement with specific terms, and investors would work through the Treasury or their bank or brokerage firm.

A qualifying 1037 exchange where no cash is received does not need to be reported on a specific tax form at the time of the transaction, as the tax deferral is automatic. This differs from other exchanges, like a 1031 for real estate, which have specific reporting requirements.

Despite the lack of a specific reporting form, the bondholder must maintain accurate personal records. It is necessary to track the original purchase date and cost basis of the surrendered bond. This information is needed to calculate the taxable gain or loss when the new bond is eventually sold or redeemed.