Limiting 1031 like exchanges and what it means for the real estate market

Similar real estate exchanges, or 1031 exchanges, have been an integral part of real estate investing for many years, dating back to the Tax Act of 1921. Although these rules have evolved over time, the main purpose has remained the same. : 1031 exchanges allow real estate investors to defer capital gains tax on disposed property if they acquire a new property of equal or greater value within the prescribed period.

Under current guidelines, real estate can be traded as long as it is “held for productive purposes in trade or business or for investment purposes”. Similar real estate exchanges may include rental housing, commercial buildings, land, retail, etc. However, the changes proposed by the new Biden administration could have negative implications for the real estate market and real estate professionals.

Context of similar exchanges

Like-for-like exchanges allow taxpayers to exchange similar real estate and defer recognition of a gain. A deferral of gain is currently permitted under the view that the taxpayer entering the exchange is merely changing their investment vehicle. As stated in Section 1031 of the Internal Revenue Code, taxpayers may sell appreciated real estate that is used for business or investment purposes and defer tax on the gain if taxpayers reinvest in similar property. In other words, the appreciation of the asset upon exchange is not eliminated, but simply deferred to a later time when the taxpayer eventually sells the asset received upon exchange. Why is 1031 Exchange so important? Similar transactions allow real estate professionals to grow and diversify their portfolios, with limited federal tax implications.

What is considered a 1031 exchange? To qualify under Section 1031, there must be an exchange of real property held for productive purposes in a trade or business or for investment purposes only for property of like nature to be held for productive purposes in a trade or business. or for investment. Items such as stocks, bonds, notes and partial interests in partnerships are not eligible. Personal property and property held primarily for sale are also not eligible. The definition of a property of the same nature is extremely liberal. For example, commercial real estate could be exchanged for agricultural land and, under the current definition, could receive like treatment.

Biden administration tax proposal

As part of the administration’s fiscal year 2022 revenue proposals, also known as the “Green Paper,” the Biden administration is proposing to limit 1,031 like-kind exchanges. Proposed change to IRC Section 1031 would limit the amount of gain that could be deferred on a like-kind exchange if the gain exceeds $500,000 per year for a single taxpayer, or $1 million in the case of married persons filing a joint return return. Therefore, any gain from similar trades that exceeds $500,000 or $1 million would be subject to capital gains tax.

In addition to limiting the amount of gain deferred under 1031, the Green Paper also proposes that long-term capital gains be taxed at ordinary tax rates for taxpayers with adjusted gross income over $1 million. Under the Green Paper, the top ordinary income tax rate would increase from 37% to 39.6% for married taxpayers filing jointly with taxable income over $628,300 and for single taxpayers with taxable over $523,600. Limiting the amount of gain that can be carried forward on 1031 like-kind exchanges, coupled with increasing tax rates on long-term capital gains, has the potential to skyrocket the tax bill of high-income real estate professionals.

Timeline for 1031 Limited

When finalizing the transaction process for 1031 similar changes, there is a strict 180-day policy when identifying and exchanging 1031 goods. If a taxpayer fails to complete the transaction within the 180-day period, the gain is recognized and included in taxable income. A taxpayer interested in a like-kind exchange has 45 days to identify potential replacement properties after the transfer of their abandoned property is complete. The exchanger also has 180 days from the time they relinquish their property to acquire a replacement property.

The administration has proposed an effective date for the limited 1031 deferral provision for exchanges made in tax years after December 31, 2021. With the 180-day deadline in mind, taxpayers who enter into a similar 1031 exchange on or after July 5, 2021, and will take the full 180 days to complete, will have completed their 1031 transaction in the 2021 tax year, meaning the taxpayer’s deferral on exchanges is now limited if the amount exceeds $500,000 ($1 million for married spouses). With that time frame in mind, real estate investors may be racing to consider swapping properties before the tax break is eliminated.

The future of the real estate market

With these new tax proposals, affluent real estate professionals should keep a close eye on potential federal tax reform. Additionally, for real estate investors looking for their next investment in new real estate transactions, the use of joint tenancy agreements should be explored. This could be beneficial and help limit the amount of gain realized on a future 1031 rollover to ensure it falls below the limit. While this similar 1031 exchange limit has not yet been enacted, it is clear that the tax proposals would change behaviors within the real estate market, and federal income tax planning will become more difficult.