Tax proposal could jeopardize like-kind real estate exchanges
By Paul Fisher
As the like-kind real estate exchange – also known as 1031 exchange – celebrates its 100th anniversary of existence in the tax code, a proposed change threatens to undo much of the benefits.
Real estate investors can use one property’s sale proceeds to purchase another property and generally not pay federal income tax as long as the replacement property is of equal or greater in value – allowing the owner to “exchange” properties. The owner can keep “exchanging” properties and defer taxes on each realized gain until the owner ultimately cashes out. Like kind refers to the nature of the property. For example, rental property exchanged for rental property.
But a change proposed as part of President Biden’s 2023 budget would only defer up to $500,000 in gains for a single taxpayer and $1 million for married couples. It could seriously impact small businesses that frequently use 1031 exchanges to expand and upgrade.
From restaurant owners looking to grow, to apartment building investors wanting to expand their portfolio, the Biden Administration proposal would suddenly add thousands of dollars in taxes.
The use of 1031 exchanges was recently paired back as part of the 2017 Tax Cuts and Jobs Act, limiting its use to only real estate transactions, not to exchanges of personal or intangible property.
If approved, the change could impact real estate transactions in 2023.
How it works
A 1031 exchange is a way for property owners to defer income taxes on the sale of one property thereby increasing their buying capacity to purchase more expensive replacement real estate while at the same time opening opportunities for additional buyers.
For example, multi-family housing is currently in demand, and some investors are looking to build and flip new developments. Using a 1031 exchange, they can build the units – hold them for at least a year to avoid short-term capital gains taxes – and then sell.
If they purchase new property equal or greater in value, the taxes are deferred. The taxes are due if and only when the owner sells without reinvesting in other property.
1031 exchangers frequently use “qualified intermediaries” – such as banks or trust companies – to hold the money from the sale of one property until they find another property to buy. Under IRS rules, the investor has 180 days to use the money for a new property and receive the 1031 tax deferral.
Some 1031 critics claim investors are “getting away” with not paying taxes – but that is entirely untrue. When an investor ultimately cashes out of the real estate, the taxable gain at the time includes the deferred gains on all previous exchanges.
Suppose an investor has a property originally acquired for $5 million and depreciates it over the years to a net book value of $3 million. If that investor uses a 1031 exchange to reinvest sale proceeds of $6 million, they would a have $3 million deferred gain (proceeds less net book value). The replacement property, although acquired for $6 million would only have a tax basis to depreciate of $3 million (acquisition less deferred gain).
Communities benefit because investors have more cash on hand by deferring taxes to continue development and improving properties.
Bottom line
If you are considering a 1031 exchange, we advise doing it sooner rather than later because the option may not be available next year.
We would also encourage you to contact lawmakers and tell them why it would be a mistake to disallow this valuable and economically beneficial real estate investment tool.
Paul D. Fisher, CPA, chairs the firm’s Construction and Real Estate Services Group. He provides accounting, auditing, tax, and business consulting services to clients in a variety of industries including construction, real estate, engineers and architects, and professional services. Contact Paul at pfisher@cpabr.com or 717-761-7210.