1031 Exchange: Possible Changes In 2022 Due To Biden Administration
WHAT IS 1031, AND WHY ARE 1031 EXCHANGES SO SIGNIFICANT?
Generally stated, a 1031 exchange, otherwise called a like-kind exchange, is a swap of one investment property for another. Although most swaps are taxable as sales, if yours meet the requirements provided in 1031, such transfer will not be taxable or will have limited tax at the time of the exchange.
Simply put, you can change the structure of your investment without recognizing any capital gain. This allows the investment to grow, deferring or delaying the payment of tax. Furthermore, there is no limit on how many times or how frequently you can do 1031 exchange. Hence, you can roll over the income from one real estate investment to another, and another, ad infinitum. The implication is that you avoid paying the taxes through rolling over the investment unless and until the investment is alienated, exchanged, disposed of, sold, or transferred. All of these while paying only the tax at the terminus or end of that one transaction.
Kind transactions allow real estate professionals to grow and diversify their portfolios, with limited federal income tax implications. In application, to qualify under Section 1031, there must be an exchange of real property for productive use in a business. Also, the same applies for investment solely for property of a like-kind to be held either for productive use in trade.
Section 1031 is a mode of asset appreciation on the exchange wherein the payment of tax is not eliminated but merely deferred until a later point when the taxpayer eventually sells the property received in the exchange.
POSSIBLE CHANGES IN SECTION 1031 IN 2022 DUE TO BIDEN ADMINISTRATION
The Biden administration has proposed limiting Section 1031 (Like-Kind Exchanges) deferral to a maximum of $500,000 for a single taxpayer and $1,000,000 for married taxpayers. The reason for this limitation is to defray the costs of the $1.8 trillion American Family Plan. President Biden's proposal would allow for 1031 exchanges by excluding particular personal property and intangible property in the deferral calculation. The president's proposal would still allow for 1031 exchanges of real property but minimize the benefit to only a deferral of $500,000 or $1,000,000 for married taxpayers filing a joint income tax return per year. Therefore, any excess of $500,000 or $1,000,000 would be subject to capital gains tax. In addition to limiting the amount of gain that is deferred under 1031, the Green Book likewise proposes that long-term capital gains be taxed at the ordinary income tax rates for taxpayers with adjusted gross income exceeding $1 million. Under the Green Book, the highest common income tax rate would increase from 37% to 39.6% for married, joint-filing taxpayers with taxable income over $628,300 and single taxpayers with taxable income over $523,600. The limitation on the amount of gain that can be deferred on 1031 like-kind exchanges coupled with increased tax rates on long-term capital gains has the potential to cause the tax bill of high-income real estate professionals to skyrocket.
SIGNIFICANT IMPACTS IN THE REFORMATION OF SECTION 1031
With these new tax proposals, high-net-worth real estate professionals should be monitoring potential federal tax reform carefully. Moreover, real estate investors considering their next investment in recent real estate dealings should be delved into the use of Tenancy in Common arrangements. This could be favorable in assisting and in limiting the amount of profit realized on an eventual 1031 deferral to ensure it falls within the ambit of limitation. While 1031, like exchange limitations, has not yet been passed, it is clear that tax proposals would shift behaviors within the real estate market. This results in federal income tax planning becoming more demanding.
One thing is clear: The elimination of 1031 exchanges, which have been part of the Tax Code since 1921, could significantly negatively impact future real estate values and the economic prosperity of small investors who own investment property. Given the pandemic-related market uncertainty, investors have been relying on the stability of their real estate holdings as a hedge against a sometimes unpredictable economy. Thus, adverse changes or elimination of 1031 exchanges could cause significant tax consequences for existing investors and erode value for wealth transfers to future generations.
WILL THE 1031 EXCHANGE BE ELIMINATED?
Before answering this question, the following must be taken into consideration as to whether the repeal of Section 1031 will accomplish what Congress intends to accomplish:
Repeal will not accomplish the goals of Congress. If the intent of Congress in repealing the law is to acquire more income for the state, reforming section 1031 is not the answer. It will instead have a significant negative impact on the future of the real estate. A repeal:
- Will not increase fairness;
- The imposition of tax over $500,000 or $1 million as the case may be taxes cash flows not wealth;
- The repeal will not raise significant revenues for the government, and most importantly;
- The repeal will cause a decline in real estate values, a drop in manufacturing, and will result to economic stagnation.
Retention of Section 31 will help achieve the goals set by Congress. The tax deferral benefit provided by section 1031 is a beneficial device for meeting all of these goals. It offers a dominant engine for the economy of the US. Like-kind exchanges boost transactional activity that results in jobs and taxable income that sustain other businesses, including small and medium-sized enterprises. Since foreign real estate and assets predominantly used outside the United States are not subject to exchange for domestic real estate and assets, the section 1031 deferral benefit directly stimulates reinvestment in US communities and businesses. This, in turn, promotes job growth within the country's borders.
Repeal of Section 1031 will have significant risks. The repeal of section 1031 will have the following adverse effects, viz:
- It will cause a decline in real estate values;
- Elimination of section 1031 would result in a considerable increase in depreciation deductions and reduced income tax revenue;
- Fewer transactions result in fewer jobs in the 1031 Exchange industry and the real estate, construction, title insurance, mortgage, and other related industries.
Repeal of Section 1031 would, in effect, tax cash flows, not wealth. Section 1031 allows an ongoing investment by the taxpayer without reducing the cash flow available for the advancement of his business. Thus, the value of assets exchanged, whether farmland, commercial or rental residential real estate, remains invested in the taxpayer's business.
Without the current treatment under section 1031, cash-strapped business-use and investment assets owners could be forced to downsize their businesses if they do not have enough cash flow to acquire replacement assets and pay tax on the gain or depreciation recapture of the old asset.
In conclusion, with all the adverse effects of the repeal of Section 1031 of the Tax Code, it is doubtful that the same will be totally eliminated. To eradicate the same would result in the downturn of, among others, real estate and other business transactions. And we all know how our society runs on commercial transactions, so it's better to be equipped with the correct information on 1031.
Even after outlining all the information above, the use of a 1031 Exchange in CRE can still seem daunting. That’s why the Leveraged CRE Investment Team at Commercial Properties, Inc. is here to help you achieve your 1031 investment goals. Contact us at (480) 330-8897 or send us an email at firstname.lastname@example.org.
Need help on your 1031 Exchange? We got you covered! We prepared a free e-book that will serve as your guide to achieve your long-term business goals or obtain that property you’ve always been dreaming of!
Phill Tomlinson is a commercial real estate broker with Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, and owner of the Leveraged CRE Investment Team specializing in investment sales and tenant/landlord representation in the Phoenix and Scottsdale submarkets. Phill applies over 21 years of experience in the Real Estate industry helping investors and owners maximize their returns.
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