100-Year Old 1031 Exchange Rules in Jeopardy

Avatar

By Tidemark Team

In our 1st edition of Tidemark Talks we began our discussion on the American Families Plan, a stimulus spending proposal from the Biden Administration that includes several changes to the tax code that would impact commercial property markets across the country. If passed as proposed, the plan calls for capital gains to be taxed at ordinary federal income tax rates of up to 39.6%, plus the current 3.8% net investment income tax, bringing the total to 43.4% versus the current 23.8%. Also, 1031 exchanges would be limited to the first $500,000 of gain and all gains would be taxed at death as if assets were sold at market value, which would effectively eliminate the step-up rule, an estate planning strategy in wide use for decades.

Last week we took a look at the ramifications of taxing gains at ordinary rates. Today, we address the proposed changes to IRC 1031 exchanges.

Rules regarding the tax-deferred exchange of like-kind property have been on the books for 100 years. Chances are you have utilized this wealth-building tool to add to or improve the quality of your own real estate portfolio through the years. In fact, up to 40% of commercial real estate transactions in California are part of a 1031 exchange according the Ling-Petrova study, a widely-recognized report on the benefits of 1031 rules.

In a fully tax-deferred exchange, a property owner sells his property (the down-leg) and reinvests all his equity into another property of equal or greater value (the up-leg). To avoid mortgage boot, the owner must take on debt equal to or greater than he had on the down-leg, or add additional cash to cover any shortfall. Third-party accommodators assist in the process to assure that the rules are followed to the letter.

Exchanging real property has several significant advantages for those looking to remain invested in real estate. First, it allows the investor to acquire more assets and/or higher quality assets over time, building wealth in the process. Second, it allows the investor to re-invest all of his equity from the down-leg, reducing the amount of debt needed to acquire the up-leg. This reduces the overall risk of the investment and increases net cash flow during the hold period. Higher cash flow frees up capital to improve the property for even better investment performance.

The American Families Plan would limit the tax deferral to just $500,000 in a given tax year, a threshold that falls well below levels associated with most commercial property exchange transactions, especially for assets that have been held for longer periods of time. And, if exchanging is not an option and gains are taxed at ordinary rates, would-be sellers are likely to hold their properties for much longer, reducing the flow of capital through the market. Transaction activity would fall over time and many potential buyers would be less inclined to acquire assets that would be even more illiquid than they are now. So, supply and demand would fall together and the additional risk of owning real estate would add a risk premium that would result in lower prices.

Presumably, the administration believes that severely curtailing 1031 rules would raise tax revenue, but the Ling-Petrova study predicts that tax revenues would actually go down from current levels due to reduced transaction activity. Raising tax rates on transactions that will not take place just doesn’t make sense to us and we can only hope that our leaders in the House of Representatives and Senate come to the same conclusion.

Our next post will address the taxing of capital gains at death. In the meantime, here are the links to the Ling/Petrova study, the actual proposal from the White House and the US Treasury Department’s Green Book overview of the American Families Plan.