1031 Exchange and How it Might be Affected by New Proposed Tax Laws

  • 3 years ago

1031 Exchange and How it Might be Affected by New Proposed Tax Laws

For nearly a century, 1031 exchanges have been a boon for real estate investors looking to upgrade their investment properties and reduce their tax exposure. 1031 exchanges allow buyers and sellers of investment/business property to defer capital gains taxes by rolling the proceeds from a sale into another investment/business property of equal or greater value. Recently, the Biden administration announced a legislative proposal, The American Families Plan, which has significant implications for real estate investors. Let’s look at how President Biden’s American Families Plan’s proposed changes to 1031 exchanges could affect your investment goals.

As of right now, the new proposal will significantly impact and limit the special tax breaks provided by a 1031 exchange. The plan also includes a number of tax-related provisions that can greatly affect real estate investors and alter the calculus of their investment decisions. As these changes move through the legislative process, it becomes increasingly important for you, as an investor, to understand the intricacies of the proposed changes and anticipate how this may affect your future investment plans. Let’s first take a look how the 1031 Exchange currently works.


What is a 1031 Exchange Today?

  • A 1031 exchange enables deferral of capital gains tax when an investment/business property is sold and the proceeds are used to purchase a like-kind property of equal or greater value.
  • The properties must be considered by the IRS as being like-kind for the tax gains to be deferred. This means that the new purchased property must also be for business or investment purposes.
  • There is currently no limit on how many times or how frequently you can do a 1031 exchange, if you follow all of the rules.
  • This process enables investors to save between 20 and 35% of the sale price of the original property that would have otherwise gone to paying capital gains tax.


Steps in a 1031 Exchange:

The following are the steps you must take in order to properly complete a 1031 exchange.

  • Close on the sale of your existing property and start looking for a replacement property.
  • Buy replacement property of equal or greater value using ALL proceeds gained from the sale of the first property.
  • Identify replacement property within 45 days of close of sale.
  • Purchase replacement property within 180 days of close of sale.
  • Must sell and buy property that is considered “like-kind” to each other.
  • Process must be handled by a Qualified Intermediary (QI).


What the American Families Plan proposes to do:

  • The Plan proposes a limit to IRC Section 1031 like-kind exchange deferral to a maximum of $500,000 of gain per tax-payer per year.
  • This means  that only the first $500,000 of the gain from an exchange can be tax-deferred and the rest would be taxed at the normal capital gains rates.
  • The proposal will also eliminate the “step up in basis” which allows heirs to use the fair market value of an asset at the time of inheritance rather than the original purchase price as the basis for capital gains when the asset is sold. This means that if the asset has a lot of built in gain, a step up in basis allows for that gain to be eliminated at the time of the owner’s death.


A Before and After Comparison

To illustrate how these changes may affect you, let’s look at a quick example of an investor selling and purchasing a new asset before the changes and after:

John purchased a residential property for $200,000 approximately 35 years ago. He recently sold the property for $950,000 and used a 1031 exchange to purchase a convenience store for $1,400,000. John used the entire proceeds from the sale of the residential property to purchase the convenience store. Here are John’s tax liabilities before and after the proposed legislation.

Capital Gains Taxable Amount: $750,000

Capital Gains Taxable Amount: $750,000

Maximum Deferrable Capital Gains: No Limit

Maximum Deferrable Capital Gains: $500,000

Amount Deferred: $750,000

Amount Deferred: $500,000

Capital Gains Subject to Tax: $0

Capital Gains Subject to Tax: $250,000

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Zahn Properties and Lyon Stahl do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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