For almost a century, real estate investors have benefited from “1031 exchanges” (also known as like-kind exchanges). The Biden Administration has proposed limiting 1031 exchanges starting in 2022. To explore the tax implications of this proposal, let’s review what 1031 exchanges are, who uses them, and what the impact of this proposed change might be.
What are 1031 exchanges?
A 1031 exchange allows someone to sell a piece of property and immediately invest the proceeds from the sale into a new property without paying taxes on the proceeds at the time of the sale. A typical 1031 exchange situation is where you sell a piece of property and, at closing, the cash goes into an escrow account. You then have 180 days to find and close on another property. Once that property is identified, your qualified intermediary will apply the cash from the prior sale to the closing of the replacement property.
A hypothetical example: Say you buy a property for $500,000 and hold it for two years. It appreciates to $1 million, and you sell it. A $500,000 gain would likely result in more than $100,000 in taxes, but if you did a 1031, you’d have the full $1 million cash to reinvest in another property. Then let’s say you held that new property for five years, and it appreciates to $2 million. If you sell it, the new property has the same cost basis as the old property (still $500,000), so the gain is now $1.5 million total ($500,000 from the first transaction and $1 million from the second). Again, you don’t pay taxes on the gain as long as you continue to use 1031 exchanges – that tax continues to be deferred. And if a real estate investor holds onto the property until death, they can pass it on to their heirs tax-free. That is, however, a portion of the new tax plan that may be changing.
Why are 1031 exchanges important?
Good tax planning is about deferral and control on timing. There are no viable tax strategies to permanently eliminate tax liability – the best option is to be able to defer and control the timing on when you pay tax. With a 1031, you get both deferral and control of timing, so you can build upon the investment without immediate concerns about taking a tax hit.
The main value of 1031 exchanges is in doing them repeatedly over time. This allows you to grow your portfolio of real estate while deferring the recognition of taxable gain into later years. If you pay the taxes up front, you have less money to reinvest in the next piece of real estate. If your goal is to build a significant real estate portfolio, 1031 exchanges help you grow it tax-free and defer tax payments until you are ready to liquidate.
In some situations, a 1031 exchange can also be helpful because it allows you to defer a gain to a later tax year in which you might have a lower tax rate.
What is an example of an SBF client using a 1031 exchange?
We have a client whose day job is in the financial services industry but has a knack for real estate investments. He built a sizable portfolio of vacation properties in North Carolina using 1031 exchanges. This enabled him to maximize the use of his money and build a portfolio in a tax-efficient way. By using the proceeds from prior real estate sales and deferring taxes, he was able to buy a much bigger property than his initial investments — he parlayed some of his vacation rentals into owning a resort hotel property in the mountains. He had always dreamed of owning a hotel in the mountains, started small, and then was able to use 1031 to realize that dream.
How common are 1031 exchanges?
Between 2016 and 2019, about 12% of real estate sales were part of a 1031 exchange, according to a 2020 survey by the National Association of Realtors. Essentially, 1031 exchanges are only common among real estate investors as long-term investment strategies. At SBF, we see a lot of 1031 exchanges because we have a lot of clients who work in real estate.
What change is the Biden Administration proposing?
In the Biden Administration’s revenue proposals for fiscal year 2022, they propose changing 1031 exchanges by limiting the amount of gain that would be allowed to be deferred. Under the proposal, if the gain exceeds $500,000 per year for a single taxpayer or $1 million for a married couple, these gains would no longer be able to be deferred — they would be subject to capital gains taxes.
How likely is it that this change will occur?
The proposal to limit 1031 exchanges is part of the Biden Administration’s budget for fiscal year 2022, and it’s essentially a request made to Congress, which must approve federal spending. Congress has until September 30, 2021 to pass a budget package (comprised of 12 spending bills), fund the federal government, and avoid a government shutdown. If they cannot meet this deadline, it is likely they will pass a Continuing Resolution, which allows the government to keep operating until the spending bills are passed. The budget must be passed by 60 votes in the Senate, which means at least 10 Republicans must approve. This brings uncertainty to the chances of significant changes to the tax code passing Congress.
What would the impact of this change be?
The immediate impact would be a rush to complete real estate transactions by December 31, 2021. As the law stands now, in a 1031 exchange situation, a real estate investor has 45 days to find a new property into which they want to invest the proceeds from the prior sale and 180 days (from the sale of the last property) to close on that new property. But as of September 1, there will be 121 days remaining to sell your relinquished property in 2021, which creates a tighter timeline.
Looking at the impacts over the long term, it’s clear this change will shift behavior within the already chaotic real estate market. It remains to be seen exactly how behavior will change. But we can expect that those with short-term investment goals may sell quickly and get out of the real estate market, while those with long-term real estate investment goals may buy up a large number of properties to get in on last-minute 1031 exchanges.
The budget implications of the change are up for debate, because the long-term impact on revenue will depend on what investors do in response to the change. According to estimates by Congress’ Joint Committee on Taxation, 1031 exchanges were projected to save investors $41.4 billion between 2020 and 2024, but this does not take into account how many of the transactions would have exceeded the new threshold of $500,000.
What do you advise clients to do?
Talk to your CPA and your financial advisor as soon as possible if you have long- or short-term real estate investment goals that include the possibility of using 1031 exchanges. And keep in mind that real estate transactions take time. If you wait until the end of 2021 to sell property and hope to reinvest those funds, you may find that the clock has run out. Reach out to us at info@sbfcpa.com if you have any questions about the tax implications of the new proposed rule on your investment portfolio.