The results of the presidential election could mean major changes ahead for Section 1031 Tax Exchanges (also known as like-kind exchanges), which many investors use to defer taxes on profits from their real estate transactions.
Over the summer, Joe Biden’s campaign released a $775 billion proposal to increase childcare and care for the elderly that would be funded by changes in taxation for real estate investors with incomes of more than $400,000.
In July, Bloomberg reported that a senior campaign official said a Biden administration “would take aim at so-called like-kind exchanges, which allow investors to defer paying taxes on the sale of real estate if the capital gains are reinvested in another property. The official also said they would prevent investors from using real-estate losses to lower their income tax bills.”
With Biden preparing to take the oath of office in January, the possibility of the elimination of 1031 exchanges may prompt investors to move more quickly on their real estate transactions to take advantage of tax breaks before they disappear.
NOT A DONE DEAL
Though some investors may be driven to act, this is not the first time 1031 exchanges have been under fire or have faced a proposed prohibition. The incoming Biden administration must also move any tax legislation through Congress, and if Republicans retain control of the Senate, they are unlikely to pass a bill without significant compromises.
The real estate industry also is likely to strongly oppose the changes, citing its negative impact on the investments and its disruption of local real estate markets. The Federation of Exchange Accommodators, a 1031 industry group, recently noted that it has been meeting with key members of Senate and House tax-writing committees to underline the economic importance of like-kind exchanges.
A recent study by two real estate professors sponsored by a coalition of real estate industry associations shows that proposals to eliminate real estate tax exchanges would likely produce a series of negative effects including “a decrease in real estate investment, increase in investment holding periods, and an increase in the use of leverage.” Renters, too, might suffer due to higher rents, particularly in higher-tax states.
RECENT REGULATORY CHANGES
The Biden proposals come on the heels of several changes made by the Internal Revenue Service that provided more specific definitions of real property covered under a 1031 exchange. Finalized on Nov. 23, the new rules address the definition of real property under section 1031 and also provide a rule addressing the receipt of personal property that is incidental to real property received in a like-kind exchange.
The 2017 Tax Cuts and Jobs Act (TCJA) limited like-kind exchange treatment to exchanges of real property, the IRS said in a statement. As of January 1, 2018, exchanges of personal or intangible property such as vehicles, artwork, collectibles, patents, and other intellectual property generally do not qualify for nonrecognition of gain as like-kind exchanges. Also, like-kind exchange treatment applies only to exchanges of real property held for use in a trade or business or for investment. An exchange of real property held primarily for sale does not qualify as a like-kind exchange.
Under the final regulations, real property includes land and generally anything permanently built on or attached to land. In general, real property also includes property that is characterized as real property under applicable State or local law. In addition, certain intangible property, such as leaseholds or easements, qualifies as real property under section 1031. Property not eligible for like-kind exchange treatment prior to enactment of the TCJA remains ineligible. Neither the TCJA nor the final regulations change whether the properties exchanged are of like kind.
We will continue to closely monitor changes involving 1031 tax exchanges in the months ahead. Contact us for a consultation to learn more about how we help businesses navigate the complexities of real estate transactions and of the 1031 tax exchange process.