For decades, real estate investors and entrepreneurs who own investment properties have been able to defer capital gains taxes on them under a program known as a 1031 exchange, named for an IRS code section. However the program, also called a "like-kind exchange," may be altered by the American Families Plan proposed by President Biden in April 2021.
“Every administration zeroes in on the 1031 exchange as a potential tax policy fix," said Keira Rawlinson, Certified Exchange Specialist® and manager of City National Bank's 1031 exchange qualified intermediary service. “They think of it as a tax loophole for wealthy people, but the reality is that this is used by many small business owners and by families as an estate planning tool to build a multigenerational real estate portfolio."
Currently, real estate investors and business property owners can defer paying taxes if they follow the requirements of the 1031 exchange program. However, possible changes to the program are being discussed.
Proposed changes to the policy would cap the program at $500,000, which would mean only profits up to that limit would be eligible for deferred capital gains taxes. However, that figure is just an early proposal at this point.
“We don't know what the final policy will be yet," said Rawlinson. “It could be capped at $5 million or not capped at all in the end."
The idea of the $500,000 cap is to limit the program to “Mom & Pop" investors rather than large-scale investors, but Rawlinson said that if the cap is imposed, smaller investors will still be impacted. For example, she said, if a couple purchased investment property for $100,000 decades ago, it could be worth well more than $600,000 today.
“Before 2018, 1031 exchanges could be used for all types of investment property, not just real estate," said Alan Wolberg, a senior wealth planner with City National Bank. “As long as you were selling property held for investment or for productive use in business and buying something similar, you could defer capital gains taxes. The Tax Cuts and Jobs Acts of 2017 eliminated the ability to use the exchange for anything other than real estate."
1031 exchanges are a common strategy to use for real estate investors because deferring the capital gains taxes on a sale allows them to roll more of their profits into a new purchase, said Jeffay Chang, a senior trust advisor with City National Bank.
“For example, if you bought a building for $1 million that's now worth $2.4 million, you're able to defer taxes on $1.4 million in profit," said Chang. At the current capital gains tax rate of 20% for top earners, that would be a savings of $280,000. Depending on the respective state law, taxpayer may also be able to defer state income taxes on the profits and other taxes.
The Biden administration is also proposing an increase in the capital gains tax, which could make the 1031 exchange policy even more valuable to investors and business owners because of the greater tax deferral potential.
For instance, if the capital gains tax rate for the highest income earners reaches the proposed level of nearly 40%, the capital gains tax on that $1.4 million profit would be nearly $560,000.
A 1031 exchange allows investors and business owners to defer taxes when they sell one investment property or business property and purchase another. That includes federal capital gains taxes, which currently can be up to 20%, and depreciation recapture taxes, which are capped at 25% of the gains.
High income earners may also pay an additional net investment income tax of 3.8%. In most states, investors are also charged state income tax on the profits, which can be another 10% or more depending on the state.
“It's difficult to pinpoint the exact amount of taxes you can defer because it depends on state laws and the amount of depreciation that has been taken against the asset," Rawlinson said. “But most people are liable for taxes of about 30% or one-third of the proceeds of the sale of an investment property without doing an exchange."
In order to defer all taxes with a 1031 exchange, the seller of the relinquished property needs to purchase replacement property of equal value or greater and reinvest all of the cash proceeds from the sale.
“The 1031 exchange allows investors and business owners the opportunity to forget about tax liability when they want to diversify the type or location of the property they own," said Chang. “For example, if business owners want to sell their real estate in New York and invest in real estate for a new business in Florida, they can defer taxes and have more money to invest in their business using the like-kind exchange strategy."
In many cases, buying a new property also can help meet the investor's needs, whether that's purchasing your company's building or a rental property that earns passive income without requiring active management, Rawlinson said.
“Most real estate owners love the 1031 exchange program because they can exchange one property for another indefinitely while deferring capital gains taxes," said Wolberg. “The only downside is that you must continue to buy real estate rather than have access to the cash which would result from the sale of the exchanged property."
If you're seeking to defer taxes on the sale of an investment property, it's important to make sure you follow the proper protocol to comply with IRS rules.
Remember to talk to your advisors to ensure that your property qualifies for an exchange. For instance, if you rent out a vacation home, but your own family uses it more than two weeks each year, the IRS may not view it as an investment property.
“All real estate is exchangeable if it has been held as an investment property," said Rawlinson. “That could include a building used for your business or a condo you've rented out for income."
“Like-kind" refers to a similarly priced or higher priced property, but it doesn't have to be the same type of property, said Chang. For example, an investor could sell a retail site and purchase a multifamily building using a 1031 exchange.
As a safe harbor, the IRS requires taxpayers to work with a qualified intermediary (QI), such as City National Bank or a qualified individual, to protect their interests throughout the process of a 1031 exchange. These professionals set up structures to securely hold funds from the sale of an investment property until they can be used for the purchase of a new property. Your own attorney, accountant, realtor or another family member is not allowed to do this for you.
“You must use a QI so you're never in physical or constructive receipt of the proceeds from the sale of your property and can't benefit from it during the exchange period," said Rawlinson.
When seeking a QI, pay attention to security and transparency: In recent years, several QIs have operated Ponzi schemes, using the funds from clients' property sales to fund their own lifestyles.
The clock starts ticking on your 1031 exchange as soon as you relinquish the title to the property you're selling. From that point, you have 45 calendar days to identify replacement properties. You can list three potential replacements or several replacement properties that total no more than 200% of the value of your relinquished property.
“With the real estate market as hot as it is, especially for residential investment properties, investors need to have a strategy around when and why they're selling and identify a potential property to buy before they start the clock on a 1031 exchange," said Chang.
After the sale closing date, you have 180 calendar days to acquire one or more of the identified replacement properties—and you have the option of exchanging the proceeds from one property into multiple new assets.
“Many of our clients are putting an earnest money deposit on a property before closing on the sale of their property to make sure they have something to buy," said Rawlinson. “Some are asking for a 30-day extension before closing on the sale to have more time to find a new property."
The 45-day and 180-day countdowns start simultaneously on the closing day for the sales transaction, Rawlinson said.
When your property exchange meets all the IRS requirements, you can defer indefinitely all taxes associated with the sale. And because a 1031 exchange is not a one-time-only option, investors can conduct them repeatedly to continue deferring capital gains taxes on property sales.
While investors who want to cash out on their property have been accelerating sales in anticipation of a capital gains tax increase, said Rawlinson, there has also been a small uptick in investors hoping to complete a 1031 exchange before a potential policy change. But that's not necessarily recommended.
“We try to avoid planning based solely on proposed legislative changes," said Wolberg. “We go though each individual situation and the client's goals and objectives to see if something meets those objectives rather than make changes to a plan just in case a law may change."
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