There have been a lot of tax changes over the last few years. Between the Tax Cuts and Jobs Act (TCJA), multiple COVID-19 relief bills, and the current proposed tax plans, it’s a lot to keep up with. The Section 1031 exchange is one of the most important tools investors use when dealing with real estate and therefore, it’s crucial for real estate investors to understand the legislative changes that have taken place in the midst of the chaos of the past few years.
What are 1031 exchanges?
Section 1031 exchanges have been part of the U.S. Internal Revenue Code since 1921. A 1031 exchange allows an investor to roll the proceeds from a real estate sale into a future purchase of a like-kind asset without paying capital gains tax on the sale. The law allows investors to continuously roll over capital gains into new replacement properties, effectively deferring capital gains tax until the investor passes away. Often, if the assets are passed down to an heir, the heir will be able to step-up the basis of the asset to fair market value (FMV) on the date of death and wipe out the deferred capital gains tax bill entirely.
Previously, IRC Section 1031 could be used to swap personal property and intangible assets. However, the TCJA changed that by limiting Section 1031 exchanges to only real property.
What is real property?
The IRS issued final regulations on December 2, 2020, defining real property as it pertains to Section 1031 as land and improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land. Taxpayers must do a facts-and-circumstances analysis to determine if their asset(s) qualifies under this definition.
As mentioned above, improvements to land are considered “real property,” but they must be either inherently permanent structures or structural components of inherently permanent structures. Inherently permanent structures are buildings and other distinct assets permanently affixed to real property. Examples might include in-ground swimming pools, roads, paved parking areas, etc. Structural components of inherently permanent structures include walls, doors, wiring, plumbing, HVAC systems, etc.
One silver lining the final regulations provided was a safe harbor for incidental personal property included with an exchange of real property. Personal property is incidental to real property acquired if the fair market value of the personal property transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement real property.
Are 1031 exchanges going away?
President Biden’s current proposed tax plan limits the amount of gain that could be deferred in a Section 1031 exchange to $500,000 ($1,000,000 for married individuals filing a joint return). It is unclear if the proposed limitation applies per taxpayer transacting the exchange or per transaction.
There’s speculation inside the industry that the elimination of 1031 exchanges will be detrimental to the real estate market. If the 1031 exchange is eliminated, there is potentially an opportunity to offset the gain resulting from the sale of the property by acquiring another piece of property in the same year as the sale occurred, performing a cost segregation study, and utilizing bonus depreciation which is available under current law to offset the gain from the sale.
Another piece of the current administration’s tax plan is to raise the tax rates on long-term capital gains, so if tax rates go up and investors are unable to defer gains with 1031 exchanges, it will be a double whammy to investors. The good news is, if President Biden’s proposal passes through Congress, any changes will likely not be retroactive. So, if you’re considering a 1031 exchange with a property you currently hold, now may be the time to take action.
It can be hard to navigate the myriad of recent tax law changes and they don’t seem to be stopping. We are only a phone call away from helping you get the most out of your investments.
