Under Section 1031 of the Internal Revenue Code (“Code”), a taxpayer may defer recognition of capital gains on exchanges of qualifying property in a process known as a “like-kind exchange” or “1031 exchange.”
Under the Tax Cuts and Jobs Act of 2017, Code Section 1031 applies only to exchange of real property and not personal or intangible property, effective January 1, 2018. Whether real property is “like-kind,” and therefore eligible for a 1031 exchange, refers to its nature or character and not to its grade or quality. Virtually all real property is like-kind to other real property; for instance, an exchangor can swap an office tower for a shopping center.
Section 1031 does require, however, that the property being exchanged must be held for productive use in a trade or business or for investment, must not be held primarily for sale (that is, as inventory), and must be exchanged solely for property of a like kind to be held for productive use in a trade or business or held for investment. That said, investors can exchange real property held for investment for real property to be used in a trade or business.
Not all like-kind exchanges have to be between two parties, however, as the Code and accompanying Treasury regulations permit deferred exchanges that meet certain requirements:
- First, a qualified intermediary (“QI”) must facilitate the 1031 exchange by holding the funds from the sale of the relinquished property and using them to acquire the replacement property, so that the funds are never accessed by the exchangor directly.
- Second, an exchangor must provide an unambiguous written identification, to another party to the exchange (which can include the QI) of the replacement property prior to midnight on the 45 th day following the sale of the relinquished property.
- Third, the exchangor has 180 calendar days from the close of the sale of the relinquished property to acquire the replacement property.
In May of 2021, however, President Joe Biden originally proposed limiting the deferral of gain on like-kind exchanges. This past March, the President’s 2023 fiscal year budget plan reiterated the administration’s prior proposals. That is, deferral of gain on 1031 exchanges would be limited to $500,000 per year for single taxpayers, and $1 million for married taxpayers filing jointly. Any gain from the exchange must be recognized in the year of the exchange at the maximum capital gains rate. What’s more, the budget proposal also would increase the capital gains tax rate from 20% to 39.6%. For example, a single taxpayer who purchased a property for $100,000 and sells it for $1 million, would recognize gain in the year of the exchange on $400,000 of the $900,000 gain—and would do so at a 39.6% rate. As the 3.8% tax on net investment income also would apply to the sale, this results in a whopping tax bill of $222,000 on the exchange.
Given the recent increase in property values and the possibility that the administration’s proposals may become law, now could be a good time for real estate investors to consider like-kind exchanges of their holdings in order to lock in deferral of significant gains. Given the chilling effect this proposal could have on the real estate market, however, it may be challenging for it to gain the simple majority of votes in the Senate required for it to become law.
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