As part of the Biden administration’s $1.8 trillion “American Families Plan,” real estate investors can expect changes to the 1031 tax code with regards to like-kind exchanges of investment properties.
Like-kind exchanges allow investors to sell one property while rolling their profits directly into the purchase of a new property. The property for the exchange must be identified within 45 days of closing on the original sale. The entire transaction must complete within 180 days. Any taxes on capital gains from these like-kind exchange sales are deferred, as outlined by the 1031 tax code.
Concerns and Benefits of Like-Kind Exchanges
Understandably, real estate experts and investors are concerned about the proposed tax changes. According to the most recent reports of the new plan, the changes would affect investment profits that exceed between $400k-$500k. Like-kind exchanges make it possible for investors to grow their wealth, defer taxes, and collect rent on real estate, including single-family rentals, multi-family, and net-lease properties, like single-tenant Walgreens, 7-Elevens, and McDonald’s. The Biden administration’s plan looks to use this gain in tax revenue to further invest in early education endeavors by nearly doubling taxes on long-term capital gains for the wealthy from 20% to 39.6%. Estimates have reported that revising 1031 could add $19.6 billion in tax revenue over 10 years.
Like-kind exchanges were initially intended to benefit farmers insofar as allowing them to trade between property, livestock, and equipment. But over time, other real estate investors have been able to take advantage of the 1031 tax code. By 2015, annual tax savings had grown to $5 billion. In the fourth quarter of 2020, $16.4 billion was invested in triple-net properties, up 7% from 2019. According to a study conducted by Ernst and Young, like-kind exchanges provide 568,000 jobs, generating $55 billion/year and $27.5 billion in labor income.
Opposition to Revisions of the 1031 Tax Code
With news of the proposed plan to revise the policies surrounding 1031 and like-kind exchanges, 31 trade associations, including the American Farm Bureau Federation, American Hotel and Lodging Association, Mortgage Bankers Association, Institute of Real Estate Management, International Council of Shopping Centers, CCIM, and the National Association of Realtors penned a letter to Janet Yellen and members of the Senate Finance and House Ways and Means Committees, urging them to recognize how vital 1031 is to the nation’s economic growth.
Suzanne Baker, general counsel for Investment Property Exchange Services and co-chairperson of the Federation of Exchange Accommodators, says that the Biden administration has a “misguided view” regarding the proposed changes. More real estate investors will become more likely to hold onto their properties with the proposed change due to the revised tax code. The resulting impact is a decreased number of transactions, stifling economic activity, reducing property values, and ultimately, decrease the national real estate market’s supply and demand.
Uncharted waters are ahead for real estate investors. While the Trump administration has already revised the 1031 tax code regarding art and equipment sales, the real estate sector has been relatively untouched since its inception in 1921. As of early 2021, individual investors and limited partnerships control more than $7 trillion in residential and commercial properties. Many real estate experts now see a mad rush to sell properties and close deals more quickly than ever before. Deloitte advocates that real estate investors become hyper-aware of their tax compliance to prepare for the incoming changes. Property investors should take to heart these six pieces of advice moving forward:
- Utilize appropriate data integrity to track like-kind exchanges at the transactional level
- Make sure all underlying assets and conditions of the exchange meet the requirements of like-kind exchanges
- Reconsider depreciation for capital assets
- Divide properties to avoid the $500k ceiling
- Consider alternative business models and tax planning to reduce additional taxable income
- Use bonus depreciation to offset capital gains while keeping in mind that this depreciation phases out in 2023
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