Section 1031 Background
The American Families Plan proposed by the President in April pays for some of its spending initiatives by making significant changes to the Section 1031 Exchanges. The suggested alterations continue the historical swings in the relationship between tax laws and investors.
The first tax-deferred like-kind exchange was authorized as part of The Revenue Act of 1921, when the United States Congress created Section 202(c) of the Internal Revenue Code, allowing Investors to exchange securities and non-like-kind property unless the property acquired had a "readily realizable market value."
These non-like-kind property provisions were quickly eliminated with the adoption of The Revenue Act of 1924. The Section number applicable to tax-deferred like-kind exchanges was changed to Section 112(b)(1) with the passage of The Revenue Act of 1928.
In 1935, the Board of Tax Appeals approved the first modern tax-deferred like-kind exchange using a Qualified Intermediary (Accommodator) and the “cash in lieu of” clause was upheld so that it would not invalidate the tax-deferred like-kind exchange transaction.
The 1954 Amendment to the Federal Tax Code changed the Section 112(b)(1) number to Section 1031 of the Internal Revenue Code and adopted the current definition and description of a tax-deferred like-kind exchange.
Tax Reform Act of 1986 Leads to Explosion in 1031 Exchanges
The Tax Reform Act of 1986 is responsible for the tremendous explosion in the number of tax-deferred like-kind exchange transactions. The Act significantly restricted the tax benefits of owning real estate and threw the tax-deferred like-kind exchange into the spotlight as being one of the few income tax benefits left for real property investors.
“Safe Harbor” Regulations Issued
In 1991, the IRS issued "safe harbor" Regulations which established approved procedures for exchanges under Code Section 1031. Prior to the issuance of these Regulations, exchanges were subject to challenge under examination on a variety of issues. With the issuance of the 1991 Regulations, tax-deferred exchanges became easier, affordable and safer than ever before.
For 30 years, there has been a safe harbor for real estate investors who use a “qualified intermediary” to hold the property sale proceeds until the investors buy a new property. While the Section 1031 safe harbor (which most investors use) requires compliance with a strict process and time deadlines, there is no limit on the amount of gain that can be deferred.
There have been several attempts to alter or remove the 1031 exchange provisions in the code, including recent changes enacted in the Tax Cuts and Jobs Act repealing personal and intangible property for like-kind exchange treatment. Thus, restricting like-kind exchange treatment to real property only. And now, it is the Biden administration’s turn with The American Families Plan.
The American Families Plan
The American Families Plan proposes restricting like-kind exchange tax deferrals to aggregate gains of $500,000 for each taxpayer ($1,000,000 in the case of married individuals filing a joint return). Gain realized on the disposition of the relinquished property which exceeds these proposed amounts would be subject to tax. This proposal would be effective for exchanges completed in taxable years beginning after December 31, 2021.
Since the proposed limitations are determined on a taxpayer’s adjusted gross income, it is unclear how the proposed law would apply to an entity engaging in a like-kind exchange such as a corporation or a partnership. For example, under current like-kind exchange rules, a partnership completes the exchange at the partnership level and not at the partner level. To apply the proposed limitations, would the partnership be subject to the adjusted gross income test, or would the partners be required to perform the adjusted gross income test on their respective partner return? The answer to that question with the latter may greatly increase the complexity of a partnership tax return.
Also proposed in The American Families Plan is the elimination of the 20% preferential tax rate for long-term capital gains effectively taxing long-term capital gains at ordinary income rates for taxpayers who meet the adjusted gross income threshold of $1,000,000.
If implemented, both proposals could drastically alter the real estate and farming sectors in our economy.
Planning for a Possible Tax Change
While it is not possible to know what changes will be adopted or how the proposed $500,000 exemption will be calculated, here are some things for real estate owners and investors to consider:
- Real estate owners planning a sale and exchange in the next 12 months might expedite their timetable and act now and close the transaction before year end.
- Real estate investors should consider investing lesser amounts in individual properties. By investing in additional properties (but with a smaller amount of equity in each one), investors will be able to take advantage of the $500,000 exclusion more often (i.e., when each property is sold).
- Consider selling real estate and in the same year you acquire new real estate. By utilizing the services of a cost segregation study on the newly acquired real estate you may be able to use bonus depreciation in the current year to offset a portion or all of the gain.
- Estate Planning. People with a significant net worth should consider estate planning. Investors may structure ownership of their real estate through irrevocable trusts or implement a gifting plan and break their investments into smaller portions.
Taxpayers are encouraged to plan Section 1031 like-kind exchanges with their RINA tax advisor.