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Proposed Changes to 1031 Exchanges for Real Estate Investors A 1031 exchange—or like-kind exchange—has a slew of potential benefits for taxpayers, especially those who invest in real estate. This type of exchange allows you to sell a property or a piece of property and reinvest the proceeds of that sale into the purchase of a new property without having to pay taxes on the capital gains at the time of the sale. Right now, there are a number of proposed changes that may be on the horizon for 1031 exchanges that could directly impact real estate investors. As a result, it is important to keep up-to-date to understand how this may impact 1031 exchanges going forward.
How Do 1031 Exchanges Work?For an exchange to qualify under Section 1031, the property that is being sold (the “relinquished property”) and the property being purchased (“replacement property”) has to be held for use in either a trade, a business, or for investment. In general, the definition of like-kind in real estate is rather broad, however, for the purposes of Section 1031, it could be any other real estate purchase. To put it another way, in a 1031 exchange, you sell a property and at closing, the money goes into an escrow account after which you have 180 days to acquire and close on another property. The sale proceeds from a relinquished property have to be held by a qualified intermediary until they can be applied to the purchase of a replacement property. Once a property is identified, the intermediary will use the cash available from the prior sale to close on the replacement or new property. With a 1031 exchange, it is possible for investors to keep deferring capital gain payments indefinitely throughout the course of their lifetime. Upon death, the assets can then be passed on to their heirs without any capital gains tax. Overall, these exchanges makeup about 6 percent of all U.S. commercial real estate sales and cost the Treasury between $4 to 6 billion annually.
What may change?Currently, there isn’t a cap on the amount a taxpayer can defer taxes one in a given year. However, under the Biden administration, this could all change. President Biden’s revenue proposals for the fiscal year 2022 could put a limit on the amount of capital gain that can be deferred for like-kind exchanges to $500,000 for individuals and $1 million for married couples. The proposal is a part of the administration’s budget for 2022 and Congress. The proposal would also raise the capital gains tax rate from 23.8% to 43.4% for households with over $1 million in income. What this means is that households that have over $1 million in income will be subjected to the increased capital gains tax. It is believed that good tax planning involves control of timing and deferral. While there isn’t a way to permanently remove tax liabilities, it is believed that deferring and controlling the timing when you pay tax is the best option. This is because it allows you to build upon investments without having to be too concerned about paying a large chunk of capital in taxes and defer these payments to a later tax year in which there might be a lower tax rate; this is especially beneficial in 1031 exchanges. By doing this repeatedly over time, investors are able to grow their portfolios. If taxes were paid upfront, they would have less money to reinvest and this is how 1031 exchanges are beneficial to investors as it allows them to grow their business tax-free while deferring tax payments until a later date or until they’re ready to liquidate their assets. If you sell an investment property, 1031 exchanges are available regardless if you file taxes as an individual, LLC, C, or S corporation. Also, if your family owns properties individually and through a variety of entities that includes partnerships and trusts and aren’t planning on selling them in the short term, you can still benefit from 1031 exchanges. Approximately 12% of real estate sales were part of a 1031 exchange between the years 2016 and 2019 according to a survey conducted by the National Association of Realtors. These exchanges are only common among real estate investors as long-term investment strategies.
The Potential ImpactAs of right now, real estate investors have 45 days to find a new property to invest the proceeds from the sale of their relinquished property to a replacement property and an additional 180 days from the sale of the relinquished property to close on the replacement property. While the proposed changes to 1031 exchanges would impact both large and small real estate investors alike, the impact will be mostly felt by larger investors making capital gains of over $500,000. It is possible that the impending changes to the exchange would result in short-term investors liquidating assets while long-term investors rush to buy a large number of properties in an attempt to avoid the capital gains taxes for gains over $500,000. There could also be an impact where there is a reduction in housing. Industry experts estimate that about a third of 1031 exchanges relate to apartment transactions. Changes to the 1031 exchange could reduce the incentives for landlords to sell their properties and this could result in a reduction in the construction of new apartments which will affect the number of new constructions of apartment units as well as construction jobs. Another impact of the change in legislation would be price increases. This is because of the reduction in supply that would result from a decline in the number of deals. In addition, prices would increase because with investors not being able to recover this loss, they may increase sale prices and/or increase rents of their properties. The like-kind exchange has been beneficial to investors and their ability to build a real estate portfolio while deferring tax payments. However, it is possible that limits to this exchange could be proposed in the near future. Although the like-kind exchange has been helpful for investors, the Biden Administration’s budget for the fiscal year 2022 estimated that between the years 2022 and 2031, the federal government would have an estimated $19.55 billion in additional tax revenue by limiting said 1031 exchanges.
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