Sweeping changes to the 1031 exchange tax deferral is a cornerstone of President Biden’s American Families Plan, which has a goal to raise $1.8 trillion to finance new social programs. While the bill has not yet reached the Congress floor, real estate investors are already beginning to worry about the implications of this proposal that may require new approaches to financial planning.
Find out the answers to “what is Biden’s tax plan?”, as well as learn how a 1031 exchange works and what types of changes may be in store if the Biden tax plan is approved as-is by Congress. Plus, we’ll explore a few tax-advantaged options for other ways on how to reduce capital gains tax.
Also called a “like-kind” exchange, a 1031 exchange is named after Section 1031 of the Internal Revenue Code. It gives a tax deferral to real estate investors on the gains made from a property sale, if they use the sale proceeds to buy a similar investment property within 180 days. It can be an effective way to continually buy and expand your real estate portfolio without having to pay capital gains tax each and every time you sell an existing property.
Additionally, there are currently no limits on how many times a taxpayer can use a 1031 exchange. In 2021, individuals are expected to save $5.7 billion in taxes as a result of 1031 tax deferred exchanges, while corporations are expected to save $2.3 billion.1
Real estate owners choose to do a 1031 exchange for a number of reasons. They may wish to find a replacement property with better returns or look for one that has already outsourced professional management. Investors may also wish to mix up the number of properties owned, perhaps diversifying by selling one large property in favor of several small ones. Or perhaps they want to consolidate the number of properties owned.
Whatever the reason may be, by deferring capital gains tax, the property owner can instead use the money to invest in the new property. The “like-kind” requirement of a 1031 exchange requires the deferral to be used only with property, not other types of assets. Additionally, the new property being purchased must be of equal or greater value to the one being sold. It can be less, but you won’t receive the full tax benefit during the exchange process. Finally, the relinquished property must be used for investment purposes, rather than being purchased to resell or use for personal use. Expect to hold the property for at least two years to meet these standards.
Navigating a 1031 exchange can be complex. Hiring a qualified intermediary is required and helps you through the exchange process by executing some of the requirements. After selling your original property, the qualified intermediary places the sale proceeds into a separate exchange account. You then have 45 days in which to identify a new “like-kind” property to purchase, with a total of 180 days to close.
Under Biden’s American Family plan, the New York Times reports there would be a limit on the deferred exchange amount in any one year of up to $500,000 for single tax filers and $1 million for couples. If enacted, this change is expected to generate tax revenue of $19.5 billion over a 10-year period. The vast majority of current 1031 exchanges fall over the $500,000 deferred exchange limit. In other words, the Biden plan would discourage the 1031 exchange benefit for most professional real estate investors.
These “like-kind” exchanges accounted for 10% to 20% of all commercial real estate transactions from 2010 to 2020.2 Critics argue that limiting the tax deferred exchange would stall economic growth and keep capital tied up rather than moving through the real estate market.
Another facet of this change is President Biden’s proposed increase on the capital gains tax. For households making more than $1 million annually, the capital gains rate would jump from 20% to 39.6%.2 This jump in the capital gains tax rate is definitely something to consider, along with the estate tax exemption 2021 rules if they apply to your personal financial situation. In the case of estate planning, it is beneficial to seek the guidance of a professional who can accurately assess where you stand financially based on your assets.
Keeping the potential fate of the 1031 exchange in mind, real estate investors may start to consider other alternatives that could offer better tax incentives.
A Delaware Statutory Trust (or DST) is an investment security that holds a variety of commercial real estate properties. Depending on the DST, holdings could include storage facilities, multifamily, retail, office, or industrial space. Investors buy shares of a DST to diversify their investment real estate portfolios.
One of the major advantages is that DST investments currently qualify as a 1031 exchange. Property owners may sell one or more properties, then invest the funds in a DST without paying any capital gains tax. As with any investment, there are risks involved, including illiquidity, market risk, vacancies, and more. It can be a solution for a property owner who no longer wishes to actively manage their investment real estate portfolio but still wants the tax advantage of a 1031 exchange.
However, it’s currently unclear how Delaware Statutory Trusts would be impacted by the American Families Plan. They may offer a short-term solution for property owners who are ready to sell their physical properties.
Qualified opportunity zones (QOZs) were created as part of the Tax Cuts and Jobs Act of 2017. There are approximately 8,700 QOZs across the country, which are located in low-income areas and offer tax incentives for commercial real estate investments. After selling a property, an investor can use the gains to purchase relinquished property in an opportunity zone.
There are several potential tax benefits, including a tax deferral through 2026. Any investor who purchased property in an opportunity zone by the end of 2019 would receive a 10% step-up in tax basis after five years, plus another 5% after seven years. That allows them to avoid paying capital gains tax on up to 15% of those deferred gains. For investments made after 2019 but before 2022, investors can still qualify for the 10% step-up after five years.
A 721 exchange is another real estate-related tax deferral strategy. It allows the capital gain from a commercial property sale to be funneled into a Real Estate Investment Trust (REIT) without triggering any capital gains tax. This 1031 exchange alternative has more liquidity than the others, as well as portfolio diversification. Of course, there is still risk involved, and you will eventually owe capital gains tax if and when you sell your REIT shares. However, it is a passive way to keep part of your portfolio in real estate without having to manage properties on your own.
There’s no guarantee of what will become of the 1031 exchange rules, especially with a nearly gridlocked Congress potentially impacting the passage of the American Families Plan. Stay updated with how the proposal is moving forward by staying in touch with your financial advisor and creating a strategy for multiple scenarios that may impact your income tax and capital gains tax.
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