What is the future of real estate investing without the benefit of the 1031 like kind, tax free exchange? Real estate investors have utilized this technique to grow their businesses dating back to the Revenue Act of 1921. 1031 exchanges allow real estate investors to defer capital gains taxes on disposed property if they acquire a new property of equal or greater value within the prescribed time period. Property owners utilize the 1031 exchange to “level up” into their next purchase; as long as the specific 1031 parameters are followed. Once a property is sold; you have 45 days to identify the next purchase and 180 days to close on the new property. The proceeds of the sale property must be held by a 1031 intermediary. The intermediary releases the funds when the new property is scheduled to close. This is vital because the taxpayer cannot touch the proceed $. The parameters must be met or the 1031 exchange is not considered legitimate. The taxpayer would have to pay the capital gain tax liability in this case.
The current administration is proposing a limit on the 1031 beginning in 2022. Section 1031 would limit the amount of gain that would be allowed to be deferred under a like kind exchange if the gain exceeds $500,000 per year for a single taxpayer, or $1 million in the case of married individuals filing a joint return. Therefore, any gains from like kind exchanges exceeding $500,000 or $1 million would be subject to a capital gains tax. The proposal also includes long term capital gains be taxed as ordinary income tax rates for taxpayers with adjusted gross income exceeding $1 million. The limitation on the amount of gain that is allowed to be deferred along with increased tax rates on long term capital gains has the potential to increase the tax bill of high earning real estate professionals drastically. Investors identifying and selling property after July 31, 2021 must close on their exchange property in 2020. The exchange will be taxed based on the 2022 tax laws.
The change would be significant! The 1031 is widely used throughout the real estate investing industry. The original intent of the 1031 enabled investors to grow their business and which also stimulates the economy. Business growth creates a “multiplier effect,” and it’s vital in creating vibrant communities. The “multiplier effect” results in an increase in income and consumption greater than the initial amount spent. Limiting or eliminating the 1031 may reduce liquidity in the market because holding periods would increase. Real estate investments would decrease; property prices would fall in the short term and rents will ultimately increase in the long term. The proponents for the proposal argue that it will increase tax revenue and increase social service spending from paid medical leave to tuition free college.
The fundamental questions are how will this change effect real estate investing in the long and short term, how it will affect the overall economy and will there be positive or negative effects for social spending programs?
