Clients looking to sell real estate should know the potential impact of a certain new tax proposal.
For years, Section 1031 of the tax code has been a tool for deferring taxes by redeploying appreciated proceeds into new property, essentially allowing real estate investors to avoid capital gains when they sell property if they use the gains to buy more property.
President Joe Biden has proposed severely limiting this provision by capping the amount of gains that can be deferred.
“The biggest loser from the [Biden] tax plan, as it relates to investment real estate, will be 1031 exchanges,” said Aaron Brachman, Washington, D.C. managing director, wealth manager and founding partner at Washington Wealth Group at Steward Partners in Washington, D.C.
Sec. 1031 benefits generally are available to any taxpayer, including real estate investors, landlords and others who simply own real property and hold it for productive use in any business enterprise. “For example, landlords occasionally need to pivot from one rental property to another so that property types and locations are better aligned with their business strategy, and Section 1031 allows for this substitution in a tax-efficient manner,” said Nathan Smith, director for CBIZ MHM’s National Tax Office in Clearwater, Fla. He added that developers and others who hold real property primarily for sale are not eligible for like-kind exchange benefits.
To defer 100% of the gain from the sale of a property, the seller must reinvest the sales proceeds in like-kind property of equal or greater value. To the extent the net sales proceeds are not reinvested or if non-like-kind property is part of the replacement property, the seller will have received “boot” (aka the cash or value of the non-like-kind property) and must recognize that gain, said Laura Culp, partner-in-charge in Sikich’s construction and real estate services practice in Akron, Ohio.
Culp said that typically the sale and reinvestment are not simultaneous. In these cases, the replacement property must be identified within 45 days and the proceeds reinvested within the earlier of 180 days of the sale of the original property or the due date of the tax return for the year of the sale.
“Right now, it is important to note that these are just proposals, and no legislation has been introduced, let alone passed. Still, taxpayers should pay attention because legislation may emerge quickly,” Smith said. “While the proposed caps to like-kind exchange benefits are easy enough to comprehend, there are some important questions that remain unanswered.”
The proposed effective date is for exchanges completed in tax years that begin after Dec. 31. “It suggests that in-process exchanges will be subject to the new caps even if they were initiated prior to Jan. 1, 2022," Smith said. "So if the proposal becomes law, taxpayers will need to complete both the identification and exchange parts of a like-kind exchange by Dec 31, 2021, to benefit from the current law.”
“Investors who are planning to sell real estate in 2021 and defer gains under the like-kind exchange rules should purchase the replacement property in 2021 if possible,” Culp said. “Investors might also consider reinvesting in several properties, which could generate smaller gains in the future and qualify for the lower like-kind exchange limits under the proposed law changes.”
A general strategy for dealing with low-basis investment real estate has also been to defer realizing a capital gain until after a step-up in basis has occurred at death. “This has made 1031 exchanges very attractive for decades,” Brachman added. “Then, upon the death of the original investor, the step-up in basis allowed the heirs to sell the asset immediately with minimal capital gains.” Biden’s plan could change that.
Best advice? “If there’s a business opportunity or a need to transition out of one property and into another, then do it,” Smith added. “Tax consequences shouldn’t be ignored – especially if the timing of a decision can favorably affect tax consequences. In this case, waiting could be detrimental if the exchange is not completed before the law changes.”