President Biden’s proposed American Families Plan is shining light on a popular tax deferral strategy used by property owners and real estate investors, mainly because the spending package would eliminate it in certain cases.
A 1031 exchange (named for Section 1031 of the tax code) allows someone to defer paying capital gains on real estate profits if the proceeds are reinvested in another similar property of equal or greater value within a certain time limit. Biden’s proposal would end the exchanges on real estate profits of more than $500,000 for single taxpayers and $1 million for married taxpayers.
Some view investors who use 1031s over and over as exploiting a loophole, while there is a strong argument that their repeated use contributes to an active real estate market and, therefore, stimulates the economy. Regardless, with the Biden proposal affecting only higher value real estate transactions, the exchanges would remain viable for many property owners.
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But are they worth it?
Pros and cons
As a wealth management adviser who works with high net-worth clients — many of whom own real estate assets, such as commercial buildings or rental properties — I regularly field questions about 1031s. Avoiding taxes on capital gains is always wise, right?
Investors who deal in multimillion-dollar transactions tend to get the most benefit and have the resources to best leverage these exchanges, as they continually swap a property or multiple properties for those of an equal or higher value. These investors typically have specialized advisers, attorneys and accountants on hand to ensure the exchanges are performed within the rules set out by the IRS and have mapped out strategies for their next exchange.
On the other end of the spectrum, for someone who owns a handful of smaller properties, worth a couple hundred thousand dollars each, and is ready to sell, a 1031 sounds appealing. However, there are hurdles involved, including fees, rigid regulations and potentially bringing in the assistance from professional advisers who are well-versed in navigating the exchanges. It’s enough to make someone reconsider.
Perhaps the biggest consideration is your endgame. 1031s will save investors in the short term, but ultimately the exchanges are only tax deferral strategies. Unless the property owner dies with the asset, eventually the tax on capital gains must be paid — and that may be significant after years of exchanges, or if the capital gains tax rate has increased. In addition, the Biden administration has also proposed to eliminate the step-up in basis at death benefit, which would further reduce the potential benefit of deferring taxes.
The next generation
If the owner’s intention is to hang on to the property or continue to make exchanges, there are more factors to take into account. Owning real estate comes with perpetual maintenance costs, property taxes, insurance, liability, potentially hiring employees or contractors and more. It’s up to the owner to decide if they want to continue to put in the extra work or just sell to take the burden off their hands.
There is also the next generation to consider. Would the owner’s beneficiaries or heirs even want the property or properties as part of their inheritance?
Even the tax savings may not be as much as one would think. For example, if someone owns a property purchased at $200 million that is worth $500 million when they die, the asset will get a step up in basis and the beneficiary is saved the capital gains. But the beneficiary is likely going to pay much more in estate tax. Without substantial liquidity, the real estate must be sold off quickly to pay those taxes, typically resulting in a fire sale.
Think before you swap
If Biden’s spending plan were to pass with a prohibition on 1031 exchanges for real estate profits of over $500,000, it could have a significant effect, but it could also be short-lived. Tax policy can change as often as the makeup of the government, so for long-term investors, there is little reason to panic.
Potential tax changes should never solely drive investment decisions. However, if an individual was already leaning toward a decision, such as selling a property or doing a 1031 exchange, a change to the tax code could speed up that choice.
Concerning 1031s and any potential tax changes, the best strategy is to be aware of them, think through the pros and cons, and use your adviser to come to the best decision should anything notable come to pass.
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