The American Plan for Families proposed by President Biden highlights a popular tax deferral strategy used by property owners and investors, mainly because the spending program would eliminate it in some cases.
A 1031 exchange (named after Section 1031 of the tax code) allows someone to defer payment of capital gains on real estate profits if the proceeds are reinvested in another similar property of equal or greater value. within a certain time. Biden’s proposal would end real estate profit swaps over $500,000 for single taxpayers and $1 million for married taxpayers.
Investors who repeatedly use 1031s are considered by some to be exploiting a loophole, when there is a strong argument that their repeated use contributes to an active real estate market and, therefore, stimulates the economy. Regardless, with the Biden proposal only affecting higher-value real estate deals, swaps would remain viable for many homeowners.
But are they worth it?
Advantages and disadvantages
As a wealth management advisor who works with high-net-worth clients — many of whom own real estate assets, such as retail or rental properties — I regularly answer questions about 1031s. Avoiding Capital Gains Tax values is always wise, isn’t it?
Investors negotiating multi-million dollar deals tend to have the best leverage and have the resources to get the most out of these exchanges, as they continually exchange one or more properties for properties of equal or greater value. . These investors usually have specialist advisors, lawyers and accountants to ensure that trades are made within the rules set by the IRS and have strategies for their next trade.
On the other end of the spectrum, for someone who owns a handful of smaller properties, worth a few hundred thousand dollars each, and is ready to sell, a 1031 looks attractive. However, there are obstacles, including fees, rigid regulations, and potentially the help of professional advisors who are familiar with navigating the exchanges. That’s enough to make someone reconsider.
Perhaps the biggest consideration is your endgame. 1031s will save short-term investors, but ultimately exchanges are just tax report strategies. Unless the owner dies with the asset, capital gains tax may have to be paid – and this can be significant after years of trading or if the capital gains tax rate has increased. In addition, the Biden administration has also proposed eliminating the base increase at death, which would further reduce the potential benefit of tax deferral.
The next generation
If the owner’s intention is to retain ownership or continue to trade, there are other factors to consider. Owning real estate comes with perpetual maintenance costs, property taxes, insurance, liability, potential hiring of employees or contractors, and more. It’s up to the owner to decide if they want to keep doing the extra work or just sell to get rid of it.
There is also the next generation to consider. Would the beneficiaries or heirs of the owner even want the property or properties to be part of their inheritance?
Even the tax savings may not be as significant as one might think. For example, if someone owns a property purchased at $200 million that is worth $500 million when they die, the asset will increase in base and the beneficiary will save capital gains. But the beneficiary will probably pay a lot more in inheritance tax. Without substantial cash, real estate must be sold quickly to pay these taxes, usually resulting in a fire sale.
Think before you trade
If Biden’s spending plan were to pass with a 1031 trade ban for real estate profits over $500,000, it could have a significant effect, but it could also be short-lived. Fiscal policy can change as often as the composition of government, so for long-term investors there is no need to panic.
Potential tax changes should never just guide investment decisions. However, if an individual was already leaning toward a decision, such as selling property or doing a 1031 exchange, a tax code change could speed up that choice.
When it comes to 1031s and any potential tax changes, the best strategy is to be aware of them, think about the pros and cons, and use your adviser to make the best decision if something significant happens.
Managing Director – Wealth Planning, Waldron Private Wealth
Casey Robinson is Managing Director of Wealth Planning at Waldron Private Wealth, a wealth management firm located just outside of Pittsburgh. It focuses on simplifying the complexities of wealth for a select group of individuals, families, and family offices. Robinson has extensive experience assisting multi-generational families with estate planning strategies, trust integration, tax planning and risk management.