An effort by the Biden administration that would essentially eliminate 1031 exchanges, also known as like-kind exchanges, for a broad swath of commercial real estate transactions is running into significant opposition in Congress.
Yet the fate of exchanges remains in doubt, and real estate owners and investors should continue to work closely with their advisors to ensure they maximize tax advantages of their real estate transactions ahead of any potential changes to the rules.
The U.S. House of Representatives recently eliminated the proposed caps from its version of a multi-trillion-dollar economic plan proposed by President Biden in April. Senators on both sides of the aisle have also expressed concerns about the proposed caps—a critical tool for commercial real estate investors.
Under the Biden plan, the ability to defer taxes under 1031 exchanges would be eliminated for real estate transactions with gains in excess of $500,000 for individuals and $1 million for married couples. Currently, under Section 1031 of the U.S. tax code, investors may defer capital gains taxes by using profits on the sale of an investment property to buy another similar (or “like-kind”) property.
A NEGATIVE IMPACT
In essence, the proposed caps would eliminate the benefits of 1031 exchanges for many commercial real estate investors. Like-kind exchanges were added to the tax code a century ago, and have been particularly useful for investors with smaller or mid-sized portfolios.
Real estate industry groups have said capping like-kind exchanges would significantly decrease commercial real estate investment, drive up debt, and increase investment holding periods for investors across the financial spectrum.
To avoid the proposed caps, investors may be rushing to complete real estate transactions this year, or they may try to get around the caps by dividing property into smaller entities or shifting investments into alternatives like condominiums, tenancies-in-common, series LLCs, UPREIT exchanges or Qualified Opportunity Zone Funds.
BENEFITS OF EXCHANGES
Like-kind exchanges may provide several advantages aside from the capital gains tax savings investors may accrue. Here is a sampling of a few potential benefits that might drive investors to consider an exchange:
- Depreciation. Investors are allowed to write-off depreciation of real estate investment properties for 27.5 years for residential properties and 39 years for non-residential investments. Investors can reset the depreciation clock, and defer depreciation recapture, via a like-kind exchange.
- Property management. A like-kind exchange can allow an investor to exchange an investment property that requires a hands-on approach for one that involves less time and effort or that may be managed by a professional management or rental company.
- Diversified investments. Investors can use like-kind exchanges to diversify their real estate investment portfolios. For example, they might exchange properties in a lower growth market for those in an up-and-coming area.
- Consolidating properties. While investors may diversify and add properties to their portfolios, they can also use like-kind exchanges to combine multiple, smaller properties and exchange for a single, more substantial commercial real estate investment.
- Improved cash flow. An investor might exchange properties to increase cash flow —for instance, moving their investment from a higher-tax locale to a lower-tax region to improve returns.
At Kaplan Voekler, we will continue to closely monitor legislation on the proposed like-kind exchange caps. Contact us for a consultation to learn more about how we help businesses navigate the tax implications of real estate transactions