- What is a 1031 exchange?
- How to Do a 1031 Exchange: Guidelines and Opportunity for Investors
- Will 1031 exchanges be eliminated?
- How will the new Biden Tax Plan (the 1031 exchange part) affect you?
- If the Biden plan becomes law, how will this affect the market?
- What should you consider before the 1031 exchanges tax law changes?
Looming over commercial real estate is President Joe Biden’s proposed tax laws and what that means for commercial real estate’s 1031 exchange tax law.
President Biden is attempting to edit the tax code that allows for deferring capital gains tax, thereby increasing taxes on real estate for sellers with proceeds of more than $500,000.
Before we dive into the impact of what this legislation could mean for real estate investors, let’s start with some 1031 fundamentals.
- A 1031 exchange is a swap of one investment property for another investment property that allows you to postpone paying capital gains taxes.
- Deferring capital gains on tax allows an investor who is selling an investment property and buying another one to acquire the new property with funds that otherwise would have been paid to the IRS. What’s not to love?
- This deferral mechanism only defers capital gain tax when selling an investment property. When the owner sells the replacement property, the previously deferred capital gains tax is recognized.
- A 1031 exchange can only take place with like-kind properties. Like-kind refers to the nature of the property. And for this reason, almost all real property is like-kind to each other.
- This tax law allows your investment to continue to grow tax-deferred.
- The congressional Joint Committee on Taxation estimated that 1031 exchanges may save investors $41.4 billion in taxes from 2020 to 2024 (Kate Dore, CNBC).
1031 Exchange History
Tax-deferred exchanges are not new – they’ve been available in one form or another since 1921. As the years have passed, the tax code that provides for 1031 exchanges has evolved.
According to Exeter:
- “The first income tax code was adopted by the United States Congress in 1918 as part of The Revenue Act of 1918 and did not provide for any type of tax-deferred like-kind exchange structure.”
- The Revenue Act of 1921 was the first time the U.S. Congress introduced the concept of non-like-kind exchanges, where investors could exchange securities regardless of the kind.
- This version was short-lived because, in The Revenue Act of 1924, Congress edited the law with the 1928 Revenue Act, and like-kind exchange where introduced.
- “In 1935, the Board of Tax Appeals approved the first tax-deferred like-kind exchange using a Qualified Intermediary (Accommodator) and the “cash in lieu of” clause was upheld so that it would not invalidate the tax-deferred like-kind exchange transaction.
- The 1954 Amendment to the Federal Tax Code changed the Section 112(b)(1) number to Section 1031 of the Internal Revenue Code and adopted the present-day definition and description of a tax-deferred like-kind exchange, laying the groundwork for the current day structure of the tax-deferred like-kind exchange transaction.”
In its current form since 1986, a 1031 exchange is a roadmap for selling one qualified property and buying another qualified property within a specific period.
The 1031 exchange is unique because the entire sell-to-buy transaction is treated not as a sale but as an exchange. The beauty here is that sales are taxable with the IRS, while 1031 exchanges are not. What we have here then is an IRS-recognized approach to defer capital gain taxes.
Any other strategy wouldn’t support deferring your capital gains tax in the same way. If you must pay the capital gains taxes, doing so will reduce your buying power by the amount equal to the deferred tax, i.e., Meaning your buying power would only be 70-80% of what it was before the exchange and tax payments were made.
The three major rules of a 1031 exchange are:
- The total purchase price of the new like-kind property must be equal to or greater than the total net sales of the sold property.
- All of the equity received from the sale of the property must be used to purchase the new like-kind property.
- A 1031 exchange must be set up before the close of the property being exchanged.
Besides these three major rules, many guidelines must be followed, including:
- Both properties must be held for a productive purpose in business or trade as an investment.
- The taxpayer has 45 days from the closing of the property to identify the new property. Because of this short timeframe, this is often a major reason 1031 exchanges do not come to fruition.
- The proceeds from the sale must go through the hands of a “Qualified Intermediary” (QI) and not through your broker’s hands or the hands of one of their agents or else all the proceeds will become taxable. QIs are companies that work full-time on facilitating 1031 exchanges; the tax code demands that QIs are independent organizations whose only contact with the exchanger is to serve as a QI. A Qualified Intermediary must prepare documents for your sale and have an escrow account in place ready to hold the proceeds from that sale.
- The replacement or like-kind property being purchased must be an equal or greater level of debt than the property sold. The equity from the sale must be reinvested in the new property. Any debt must be replaced with either new debt or an influx of cash. If not, the buyer must pay tax on the amount of decrease.
- The period in which the new property is received ends exactly 180 days after the date the sold property was transferred — even if this falls on a weekend or holiday — or the due date for the exchanger’s tax return for the taxable year in which the property was transferred, whichever comes earlier.
It doesn’t matter how many properties you are exchanging in or out of, as long as the trade is equal or higher in value, mortgage, and equity. But the more properties you aim to 1031 exchange the more difficult the transaction is due to the time restraints in which everything must be completed.
While you can see the benefit of the 1031 exchange, it’s vital to follow the guidelines to gain these benefits.
Who is eligible to do a 1031 exchange?
Any taxpayer is eligible to engage in a 1031 exchange with their investment property as long as the properties being sold and purchased qualify as an investment, trade, or business.
According to IPX1031, “All businesses, manufacturers, real estate investors, companies in the construction, trucking, rail, marine and equipment leasing industries, farmers, ranchers, individuals and more make good use of like-kind exchanges. 1031 like-kind exchanges are one of the few incentives available to and used by taxpayers of all sizes.”
But properties purchased with the intent to quickly sell, or “flip”, do not qualify for 1031 exchanges.
Can you do a 1031 exchange on a primary residence?
A primary residence is not considered an investment, trade, or business, and so does not qualify for a 1031 exchange.
Why wouldn’t you want to do a 1031 exchange?
- If you are in the 10%-12% income tax bracket, there would be no reason to do a 1031 exchange because they will have 0% capital gains.
- If you are exchanging a US property for a foreign asset, or vice versa. Properties in the US are not considered like-kind to foreign properties.
- If you can’t find your new replacement 1031 exchange property within the 45-day timeframe or cannot close before the 180 days are up, it would not make sense to pursue a 1031 exchange.
It’s too soon to tell if the 1031 exchanges will be eliminated.
This topic is at the forefront of many investors’ minds and is being discussed in Washington D.C. and around the country. Many companies and organizations wrote a five-page letter to treasury secretary Janet Yellen and Senate Finance and House Ways and Means committees members. The letter explained why 1031 exchanges are a crucial part of the commercial real estate industry.
If the 1031 exchange program is eliminated, millions of small investors have the potential to lose billions of dollars in property value. There have been many attempts to end this program, but lawmakers see the positive impacts it has had on society.
Unfortunately, while the economy is still recovering from the ongoing pandemic, the timing of this proposed tax reform is very poor. And any change will have an even greater impact.
Anticipation of changes in the U.S. tax policy has been incubating since the election of Joe Biden. These proposals could have considerable ramifications on your tax burden. While there has not been a concrete announcement, these proposals are serious, and it is worth considering their potential financial impact on you.
How could this change affect middle and upper-class investors?
1031 exchanges help taxpayers at every level invest for the future and create significant positive growth.
- Contrary to the narrative that the new changes to the tax code would primarily target loopholes for wealthy investors and balance the scales in taxation, most 1031 exchange participants are either small investors or sole proprietors.
- The proposed $500k cap on 1031 exchange capital gains tax deferrals is not expected to have a huge impact on middle-class investors. Why? Because middle-class investors typically buy real estate at the price point where returns would not exceed $500k per property.
- With a more compelling reason to invest in less expensive properties, there is an increased likelihood that we will see upper-class investors migrate from high-end property to smaller investments.
- With this increased competition and the holding of properties, the barrier to entry for small multi-family investments will grow. This situation makes it more difficult for the next generation of real estate investors to create wealth or even a modest portfolio.
How could the proposed 1031 exchange tax changes affect Opportunity Zone investors?
Currently, 1031 exchange property investors are not the only people in the industry who can receive tax deferrals on their properties. Investors who buy and sell in Opportunity Zones, areas in the county designated by the federal Tax Cuts and Jobs Act of 2017 and allow for certain tax advantages, would continue to enjoy deferral of taxes by investing in qualified opportunity funds.
These funds have many advantages over the 1031 exchange; the most significant is that they are much less risky due to the longer maximum incubation periods and required research before a deal is closed. However, this group of investors might see increased competition, as prospective 1031 exchange investors seek alternatives to avoid paying taxes on property sales.
If the Biden plan becomes law, there would be potentially dramatic consequences on the investment real estate market. While 1031 exchanges comprise a relatively small proportion of overall real estate activity, the ripple of their disappearance would be felt across the industry.
This change would potentially kill the provision entirely since more than 50% of exchanges exceed the $500,000 cap. Any cap would be difficult to define and manage, and as such any cap could very well freeze the market.
“Ernst & Young did a study in 2016 that concluded if 1031 was limited in any way or repealed, GDP would shrink $9 billion per year. The cost of capital will increase, real estate values will fall, and rents would rise. In our opinion, this would cause a real estate recession.” Marie C. Flavin, Esq. Sr. Vice-President at Northeast Regional Manager Investment Property Exchange Services, Inc.
How will the real estate market immediately respond to changes in the 1031 exchange tax code?
The market would likely begin to slow down. There would be a lull in real estate trading as property owners would be hesitant to sell at first. There are two reasons for this:
- Investors anticipating a short-term dip in property value are also suddenly faced with paying taxes they had not previously prepared to pay.
- The rental market would see a combination of increased holding periods, reducing liquidity, and high earners investing in opportunity zones.
As a result, investors would have a narrow window to find affordable rental properties before their options dry up.
What should investors expect in the long-term if President Biden’s plan is enacted?
Real estate trading could decrease, and property prices could fall in the interim. But this period would not last long. As more and more investors hold onto their properties:
- It would be more difficult for the next generation of investors to successfully build wealth, as prior generations before had done.
- To combat potential losses brought on by this legislation, property owners will likely begin a consistent sequence of rent increases.
The entire real estate industry and other businesses will be facing an upward mobility crisis. As growth slows, higher rents will mean a more difficult time-saving money. This change will make it harder to invest or buy real estate. Companies might no longer find it worth it to scale up to larger buildings, as they too deal with changes to the tax code.
Assuming that the proposed changes would not be retroactive and affect past or ongoing sales, and before any possible changes to the tax code that impacts 1031 exchanges, you may want to consider:
- Asking yourself? Do I have any properties that could benefit from a 1031 exchange before they are potentially taken away? Now could be your last chance to upgrade properties while deferring capital gains taxes you owe.
- It’s ultimately up to you if you want to wait and see how the possible final law might impact you.
- It is also worth being cautious of property price manipulation due to fear of changes to this bill. Deciding to trade too late or too soon may result in you ending up in a substandard deal unless you are very diligent with your research.
- Other alternatives. Currently, Opportunity Zone investments remain an upstanding option. It’s likely that these investment programs will not change under this administration because of President Biden’s keen interest in investing in infrastructure.
We recommended that you remain flexible and diligent. For many, now is the time to sell.
Keep a close eye on 1031 exchange legislation discussions and how the outcome might impact your specific situation. This will ultimately help you make an informed decision and maintain your successful position in the industry.
What else are you wondering about 1031 Exchanges?
Share your questions or comments with us below!
Northeast Private Client Group is focused is on assisting investors, owners, and syndicators of mid-market multi-family real estate properties between $1M – $50M in the Northeast and Southeast regions. We represent sellers exclusively with their best interests in mind.
We establish a trusted relationship by providing knowledge and guidance to help our clients achieve their individual goals for maximizing value and return on the sale of their real estate investment. Contact us today to learn more.
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