Will the 1031 exchanges be restricted by Congress?
The history of 1031 exchanges in commercial real estate is almost as long and complicated as the creation and evolution of the first modern American income tax code. At the turn of the 20th century, the United States government was in desperate need of revenue after entering World War I, which was a major factor in the creation of the Income Act of 1918. The Act of 1918 which created the first modern income tax code did not include a provision for similar exchanges. This meant that anyone selling one property (real estate or otherwise) to buy an identical one would have to pay tax on the gain. The idea was that this person’s position had remained relatively unchanged and that she might not have the income to pay her tax bill. The Revenue Act of 1921 changed that by creating the 1031 Exchange Structure, designed to provide taxpayer relief through a deferral strategy that encouraged real estate investors and taxpayers to continually reinvest their money.
One hundred years later, 1,031 exchanges are very common in real estate investing and have undergone a multitude of changes including threats of restriction and elimination from politicians who see them as a tax loophole or avoidance strategy. tax. Over the past two years, commercial real estate investors have been biting their fingernails over the fate of the 1031, as the Biden campaign and then the administration vowed to restrict them. It looks like similar exchanges may have dodged a bullet, but those in the commercial real estate industry should still be watching closely what the Biden administration and Congress decide to do. As many real estate investors have argued, restrictions on the 1031 would likely affect the flow of capital in real estate transactions and prevent investors from building wealth. As many tax advocates have argued, it allows the wealthy to avoid paying their fair share of taxes. Whether or not Congress decides to cap them remains to be seen, and it will be watched closely by millions of investors across the country.
Who is afraid of 1031 limitations?
A 1031 swap is a method of exchanging real estate so that all or most capital gains taxes are deferred into the future, as defined by Horvath and Trembly, an investment real estate brokerage firm. . Swaps allow real estate owners to trade their current investments for new ones without recognizing capital gains and allowing investments to continue to grow tax deferred. Commercial real estate investors can reap significant benefits from 1031 exchanges, including reinvesting in a property with potentially higher income and replacing a property with greater management responsibilities with one with less or no maintenance responsibility. , as a single tenant, net leased property.
Only investment and commercial property applies to 1031 trade, other types of real estate such as primary residences and vacation homes do not. When exchanges of the same nature were originally conceived, the tax code required that the property be exchanged for the exact same type of property. But that changed with the rewrite of the 1031 in 1990, and it’s now legal and common to swap one type of investment or commercial property for another. For example, an apartment building could be exchanged for various types of investment real estate, including vacant land or a shopping center. The vast majority of trades made are referred to as ‘deferred trades’, which means that the replacement good traded must be identified within 45 days and purchased within 180 days or until the date on which the income tax is paid. this year is due. Deferred swaps give investors more time and flexibility to structure the sale of an abandoned property and the purchase of the replacement property.
As commercial real estate investors feared, the Biden administration proposed tax reforms in May 2021 that would place a limit of $ 500,000 on 1,031 exchanges for each taxpayer (and $ 1 million for married taxpayers filing a joint return) each. year for real estate exchanges that are like- kind. The proposal stated that any gain above these limits would be recognized by the taxpayer in the year of the trade. A proposed increase in the capital gains tax from 20 percent to 39.6 percent would also reduce some of the returns to investors in CRE. Keith Strum, Director of Upland Real Estate Group, said Minnesota Attorney a limit of 1031 exchanges “would absolutely slow down the movement of capital in industry”. Strum noted that most CRE transactions are large amounts, typically greater than at least $ 1.5 million. With the proposed tax reforms, he said CRE investors would be more likely to keep their properties instead of paying up to 50% tax and losing half of their values.
The Biden administration’s reasoning for the restrictions on 1,031 exchanges and other tax reforms on investment assets is that it would increase government revenue by $ 19.6 billion over 10 years and help finance the goals of administration. But even if that estimate is correct, that $ 19.6 billion in additional revenue would only fund 1.6% of the $ 1.6 trillion infrastructure plan, according to KJ&K, an Ohio-based law firm that serves local and national businesses. Critics of the restrictions on the 1031 agree there is a need to fund growing government spending and sweeping new legislative initiatives such as COVID-19-related stimulus packages. But they say going after 1031 exchanges is misguided and could have far-reaching unintended consequences.
An analysis by the accounting firm Ernst & Young (EY) said that a repeal of 1,031 exchanges would result in reduced federal tax revenues, discourage real estate investment and negatively impact the economy by up to $ 13.1 billion per year. EY research has indicated that the 1031 encourages businesses of all sizes to locate properties that better meet their current and future needs, leading to optimal and optimal use of property and supporting economic growth. The National Association of Realtors also noted in a statement that 1,031 exchanges are critical to the advancement of the commercial real estate market, and that they are primarily used by retirees, investors and homeowners, not the very wealthy.
Stay tuned to DC
While some have called the 1031 a loophole, others disagree. “Like-nature exchanges facilitate the overall flow of the real estate investment industry, with about 15% of all real estate transactions in the United States being like-nature transactions,” argued John Harrison, DBA, of the Alternative & Direct Investment Securities Association to a letter to the Wall Street newspaper. Harrison wrote that a majority of traded properties are sold after a turn, resulting in higher amounts of tax paid over time that would otherwise have been owed. “This reinvestment speeds up the speed of money and prevents extended holding periods that lead to stagnation,” he wrote.
The Biden administration’s tax reform proposal has worried some real estate investors, and there is anecdotal evidence that it has fueled a rise in similar trade over the past two years. But many other commercial real estate investors have said they doubt the 1031 will be repealed or restricted simply because of the immense positive impact it is having on the economy. Strum, the director of Upland Real Estate Group, also said Minnesota Attorney the 1031 proposed restrictions probably came from someone who didn’t understand how they worked. Strum said that once people understand the benefits of similar exchanges to the economy, “very few people would like them to be eliminated.” For now, it looks like the 1031 can be safe, in part likely due to pressure on Congress and the Biden administration by a coalition of business groups like the Federal Exchange Accommodators and 1031 Crowdfunding. The 1031 Crowdfunding group has launched a campaign in strong opposition to tax reforms and sent over 700 letters to Congress.
In September, the House Ways and Means Committee provided draft legislation for the Biden Families U.S. Plan, which was supposed to include the proposed cap on 1,031 exchanges. However, the bill made no mention of restrictions on 1031s, which groups like 1031 Crowdfunding called a victory. “So while there is a chance that this will change, it is unlikely that the proposed changes will be reintroduced in future revisions,” 1031 Crowdfunding wrote in September on its website. Limits on similar exchanges appear to be secure for now, as Congress focuses on other changes in the real estate industry, such as housing tax credits for low-income people and reform of the housing market. zoning.
1,031 exchanges have been around since 1921, and they have a long and complicated history in commercial real estate. Despite the challenges of the past and being labeled a tax loophole, similar exchanges have survived and become a common and highly beneficial part of the tax code for real estate investors. The Biden administration isn’t the first to target the 1031, and they likely won’t be the last. While restrictions or elimination of the 1031 seems unlikely at this time, real estate players should closely monitor future developments to ensure it stays that way. As extensive research has shown, exchanges of a like nature can increase your purchasing power, allow you to reinvest in higher income properties, and exchange properties with significant management for those that require less. interview. All of this is done by deferring capital gains taxes into the future. Industry-wide, 1031s accelerate the flow of money in real estate transactions and often trigger multiple transactions that help fuel business growth. Stay tuned for the fate of similar exchanges in the nation’s capital, as this is one part of the U.S. tax code that most real estate investors don’t want to be disturbed.