The 1031 Exchange is a very popular tax deferral program with commercial real estate investors. But, recent legislative proposals seek to change or modify it in a way that could ultimately be detrimental for the real estate investment community.
In this article, we are going to discuss what a 1031 Exchange is, how it is beneficial to real estate investors, and the proposed changes under President Biden. By the end, readers will have the information needed to determine if entering into this type of transaction is the right fit for their own investment strategy.
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What is a 1031 Exchange?
A 1031 Exchange, sometimes called a like kind exchange, is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property – as long as they reinvest the sale proceeds into a new, like kind property.
In addition to the reinvestment requirement, the IRS outlines several rules (in section 1031 of the tax code) that investors must follow to achieve full tax deferral. The most prominent include:
- Investors/taxpayers have 45 days from the date of sale of the “relinquished property” to identify a replacement property.
- Investors have 180 days from the sale date of the relinquished property to close on the purchase of their identified replacement property.
- Investors must invest all of their sale proceeds into the new property. Any cash they receive is known as “boot” and it is taxable.
If investors follow all rules, capital gains taxes are deferred indefinitely. Further, real estate investors have the ability to complete 1031 Exchanges over and over, allowing their investment capital to grow tax deferred over a long period of time. This is a major benefit.
1031 Exchange Updates Under the Biden Administration
President Joe Biden took office in January of 2021 and, not long after, proposed a landmark piece of legislation known as the “American Families Plan.” With it, President Biden proposed a series of significant investments in education and families, including:
- Universal pre-kindergarten and two years of free community college
- Steps to increase tuition affordability for Historically Black Colleges and Universities (HBCUs) and Tribal Colleges and Universities (TCUs).
- Direct support to children and families by creating a national paid medical leave program
- Extension of the child tax credit and Earned Income Tax Credit.
While many of these proposals are ambitious and popular, they are also very expensive. To pay for them, President Biden has proposed a series of tax increases. One of them involves 1031 Exchanges.
Potential Impact of Changes
With regard to 1031 Exchanges, the key piece of the proposal is a plan to cap deferrals at $500,000 in profits (or $1,000,000 in the event of married individuals). Anything over that would be realized in the year that it occurs and taxed at a rate of up to 39%.
Given the popularity of the 1031 Exchange, there are a number of potential impacts:
- Lower Real Estate Transaction Volume: For those that exceed the $500,000 profit cap, it is expected that they would just hold on to their property rather than incur the tax bill. This would lower real estate transaction volume and could impact many of the jobs and industries that depend on it like title companies, realtors, lenders, and Qualified Intermediaries.
- Tax Revenue: Implementation of the cap is expected to generate $1.95B in tax revenue, which could be used to pay for the costs associated with the bill. However, it should be noted that 1031 Exchanges already generate ~$7.8B in tax revenue according to a study from Ernst & Young.
- Small Businesses: Many small businesses use 1031 Exchanges as a way to grow their footprint. For example, if a small company is successful and needs to sell their property to move into a bigger one, they often do so using a 1031 Exchange. Biden’s proposal to implement a cap could negatively impact small business growth as they may not have the cash on hand to pay long term capital gains taxes or at least prefer to use that capital to invest in their business.
So, while the proposed tax plan seems to be well intended to pay for important investments in American families, the general consensus is that it would have unintended negative consequences that can ripple through the real estate industry.
Will 1031 Exchanges Be Eliminated?
No. Under the current tax proposals, 1031 Exchanges will not be eliminated. They will be modified in a way to generate more tax revenue.
A Word About Proposals
It is very important to note that, at the time of writing, this is just a proposal. There is certain to be much discussion about this particular provision and strong opposition from the real estate industry. Even if it were to make it into the final version of the bill, it still has to be voted on – and passed – by members of both congress and the senate, which is a tall order on its own.
So, at this time, the most prudent course of action is to take a wait and see approach.
Summary of 1031 Exchange Changes
A 1031 Exchange is a type of real estate investment transaction that allows individual investors to defer capital gains taxes on the profitable sale of real property – as long as they reinvest sale proceeds into another “like kind” property. The program is very popular with real estate investors.
As part of the American Families Plan, President Biden has proposed capping tax deferrals at $500,000 in profits or $1,000,000 for a married couple. The tax revenue generated would be used to pay for a number of important social programs like community college and universal PreK.
If approved, it is expected that this new tax law would have important consequences for the real estate market including lower transaction volume and a negative impact on all of the companies and jobs that are involved in a 1031 Exchange like realtors, brokers, attorneys, and lenders.
It is important to note that this is just a proposal at this time. Passage is not imminent, but real estate investors should be aware that some portion of this tax break could potentially be eliminated and keep an eye on its progress.
Interested In Learning More?
First National Realty Partners uses its expertise to find world-class properties and multi-tenanted assets below intrinsic value. If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.