The 1031 exchange, a popular tool to create wealth by “deferring” capital gains tax on real estate investments, is on the chopping block in the “American Families Plan” put forward by the Biden Administration earlier this year. If the change is implemented it could have a significant impact on the way small investors participate in the commercial real estate market.
Under Section 1031 of the Internal Revenue Code, there is currently no limit to the amount of capital gain that taxpayers may defer. This allows a real estate investor, for example, who bought a building for $2 million and sold it later for $5 million, to defer paying taxes on her gains as long as she reinvests the proceeds into a new property within six months. She can then repeat that process, “leveling up,” indefinitely. At her death, her children can avoid all of her deferred capital gains by virtue of another provision of the Code that allows them to take a “step-up” in basis on the inherited assets.
The Administration’s proposal would is to create an annual limit of $500,000 per person ($1 million for married taxpayers filing jointly) on capital gain that can be deferred for all exchanges completed after the end of this calendar year.
The Biden Administration’s plan also proposes to treat gifts of appreciated property at death as “realization events” that trigger capital gains tax just as if the property was sold, subject to a $1 million lifetime exclusion. The proposal contemplates that certain family-owned and operated businesses would be able to defer tax on the appreciation until the interest in the business is sold. It also proposes that the tax would be payable over a 15 year period.
Real estate industry trade groups including the National Association of Realtors, the Federation of Exchange Accommodators have come out in opposition to these changes, arguing that 1031 exchanges are a net benefit for economic growth, incentive transactions of properties in which capital would otherwise remain “locked up,” reduce costs for small investors, increase property values, and create jobs. The Biden administration and other proponents of the changes argue that 1031 exchanges primarily benefit wealthy individuals and allow them to avoid tax, costing the US government tax revues that are needed to cover new subsidies for families and workers also proposed under the Administration’s plan. By one recent estimate, 12% of commercial transactions involve a 1031 exchange and more than 80% of that 12% involves small investors.
These are only proposed changes at this point. But it is important for real estate investors and businesses to track the progress of these new proposals. and consult with their attorneys and financial professionals to form a plan how to structure investments and prepare for future tax liability. These are not the only changes to tax policy proposed under the Biden Administration’s plan that will affect real estate investments, but they are significant. If the proposed changes to the 1031 exchange and transfer on death changes are implemented, they will have significant impacts on decision-making concerning which real estate asset classes and debt burdens are appropriate for a particular individual interested in leaving property to the next generation that doesn’t need to be liquidated to pay tax, as well as decision making about the timing of transactions and ownership structures. As always, good decisions need good data and keeping accurate records of the financial information concerning an investment including property appreciation, depreciation, income and expenses is the best way to be prepared.
Marcus J. Kocmur