1031 Exchange Tax Saving Opportunity
In April 2021, the American Families Plan was introduced, and with it, several potentially significant tax changes impacting Los Angeles and Orange County real estate companies, investors, and commercial property owners. The proposal called for a $500,000 cap on 1031 like-kind exchanges, a move that could limit real estate investment activity if enacted. Federal scrutiny over the popular tax shelter strategy began long before the American Families Plan; the Tax Cuts and Jobs Act of 2017 also limited exchanges and made transactions slightly more complicated, if not nuanced. The potential cap on 1031 exchanges combined with previously issued final guidance means that as real estate investors prepare to close out the tax year, important decisions about how to treat certain types of property will need to be made. To help clients, prospects, and others, JLK Rosenberger has provided a summary of key details below.
What is a Like-Kind Exchange?
A 1031, or like-kind exchange, is a deferred tax transaction. It’s a property swap. Real property owners can sell an asset and use the proceeds to purchase another property, provided certain requirements are met for property type and timeframe. Basic requirements for a 1031 exchange are:
- The property must be held for productive use in a business, trade, or investment, and is not held for sale.
- Replacement properties must be of equal or greater value, up to 200 percent more than the fair market value of the original property. There is an exception; however, it involves buying 95 percent of any number of identified properties.
- Transactions don’t need to happen at the same time, and owners can use an intermediary to hold proceeds from the first property’s sale.
- Once the first property is sold, the owner has 45 days to identify the replacement property. Up to three potential replacement properties can be identified if the owner closes on at least one.
- Start to finish, the owner has 180 days to complete the transaction.
If all requirements are met, there is a deferral of any capital gains from the sale of the first property until the replacement property is sold.
There are four types of 1031 exchanges:
- Simultaneous: A same day transaction.
- Delayed: There is a delay between when the first property is sold and when the replacement property is purchased.
- Improvement: Also called a construction exchange; this uses tax-deferred money to improve the replacement property.
- Reverse: When the replacement property is purchased before the original asset is sold.
It is important to note that “flipped” properties, vacation homes, and personal residences don’t count. Other excluded assets are inventory, partnership interests, indebtedness, stocks, securities, and notes.
Like-kind can be a misnomer, as the two property types don’t need to be the same; an apartment building can be exchanged for a rental house, for example. Like-kind exchanges can be done across state lines, too – although there would be state tax implications.
1031 exchanges have several advantages and benefits. Deferring capital gains is the most obvious and tangible benefit, especially if capital gains rates increase in 2022. Owners and investors can keep more of the profits and use it to make additional investments. It’s an opportunity to expand and diversify a real estate portfolio.
Final Regulations and Proposed Changes to 1031 Exchanges
Real estate stakeholders will remember when personal property was eligible for 1031, or like-kind, exchanges. After the Tax Cuts and Jobs Act was passed, the ability to purchase and reinvest vacation homes and other personal residential dwellings went away. Instead, a new definition of real property was introduced and eventually finalized in 2020.
Beginning for like-kind exchanges after December 2, 2020, certain types of real property and distinct assets qualify for the transaction while others don’t.
Then, after President Biden took office, attention once again turned to 1031s; this time, the talk was of eliminating them. Instead, the American Families Plan in April 2021 proposed limiting like-kind exchanges to $500,000, or $1 million for married taxpayers – but so far, nothing has been finalized. As a result, like-kind exchanges have surged in 2021.
And finally, the Biden Administration’s 2022 revenue proposal – also referred to as the Green Book – has called for an effective date of December 31, 2021, on limiting like-kind exchanges to the above-mentioned thresholds.
If passed, it would mean that real estate investors looking to reinvest eligible property within the standard 180-day timeline would have had to enter a transaction by early July to take advantage of the full timeframe by which to identify and finalize the replacement property. Now, investors who are sitting on any potential 1031 exchanges may only have until the end of the calendar year to finalize the transaction under current law.
How to Strategize
Other than offloading 1031 transactions in the current tax year, real estate investors may have another option to consider: Tenancy in Common arrangements. What this approach would do is effectively limit the amount of realized gain on a deferred future 1031 transaction. Though it won’t work for every situation, when it makes sense to share ownership rights on eligible real property, it can keep future like-kind exchanges under the proposed $500,000 cap.
The tax savings opportunity available through a 1031 exchange is an important opportunity that Orange County and Los Angeles real estate companies should not miss. Since an exchange can be a complicated process it is important to work with a provider that can properly guide you through the process. If you have questions about the information outlined above or need assistance with a tax or accounting issue, JLK Rosenberger can help. For additional information call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.