A cap on capital gains deferral through Section 1031 could have disastrous effects on the real estate market and overall economy

Since the election of Joe Biden, there has been speculation that Section 1031 of the tax code, which covers like-kind exchanges of real property, could be changed or potentially eliminated. With the release of the proposed FY2023 budget Green Book, it seems 1031 is again in danger.

The proposed cap on deferred gains for 1031 exchanges

The US Treasury has released its General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals, which contains the following regarding 1031:

The proposal would allow the deferral of gain up to an aggregate amount of $500,000 for each taxpayer ($1 million in the case of married individuals filing a joint return) each year for real property exchanges that are like-kind. Any gains from like-kind exchanges in excess of $500,000 (or $1 million in the case of married individuals filing a joint return) a year would be recognized by the taxpayer in the year the taxpayer transfers the real property subject to the exchange. The proposal would be effective for exchanges completed in taxable years beginning after December 31, 2022.

If this proposal were to pass, there would be a $500,000 per year cap on individual gains that could be deferred through Section 1031. Any amount greater than $500,000 would be taxed in the year the property was sold.

Why changing Section 1031 is a bad idea

The goal of the proposal is to limit the amount that can be deferred by wealthy individuals while still allowing smaller property owners to benefit from 1031. The assumption seems to be that those who defer gains in excess of $500,000 are receiving an unfair benefit, and that the public would be better served by collecting those tax revenues now. This is an issue for a number of reasons:

First of all, it’s important to remember that taxes are deferred through 1031, not avoided, and it’s been found that investment involving a 1031 exchange can ultimately result in the collection of more taxes paid in the long run. This is because 1031 exchanges actually promote additional tax opportunities: property owners may have less depreciation ability on their replacement properties, and when the replacement property is eventually sold, there will likely be an increased taxable gain amount, resulting in greater overall tax revenues from the property owners.

Additional taxes can also be collected in the form of income taxes from all of the professionals and participants involved in the purchase and sale of real estate. There’s no reason to believe that this proposal to limit 1031 exchanges would result in “more” tax revenues being collected – quite the opposite: it could result in lower tax revenues from both the property owners and real estate professionals.

Even the shortsighted view that the proposal would significantly increase tax revenues in the near term may be misguided, for it relies on a belief that wealthy investors will continue to sell property as planned, but now will be paying tax in the year the property is sold, increasing near-term tax revenues. However, this may not be the case, because wealthy investors may attempt to “wait out” the current rules and sell down the road in more favorable conditions.

Edward Fernandez, President and CEO of 1031 Crowdfunding, outlined his issues with the proposal in an op-ed for CNBC.

“If the proposal is approved by the House of Representatives and Senate, wealthy investors who are savvy would likely just hold on to property in response — expecting that the tax code will change once again in the future and restore a more expansive environment for 1031 exchanges. Their reluctance to sell property in the meantime would slow transaction volume and create an unintended ripple effect within the real estate sector.”

The result could potentially be a slowing down of the real estate industry as a whole. According to an EY report, like-kind exchanges could add $55.3 billion to the economy in a single year and employ more than 500,000 workers. Given that the potential tax revenues generated by the proposal have been estimated at less than $2 billion, it doesn’t seem like a smart move.

The effects of changing 1031 on the economy beyond real estate

Altering 1031 could have a wide-ranging economic impact, as small businesses rely on 1031 exchanges as part of growth strategies. “For example,” said Fernandez, “if a company owns a smaller property and wants to purchase a larger one (or numerous properties) to allow for continued growth, it wouldn’t be able to benefit from the real estate appreciation and tax deferral provided by a like-kind exchange, thus stalling potential business expansion.”

One area that will be of vital importance to businesses in many sectors is the repurposing of office space. The COVID era has had a significant effect in this area, with one report saying, “the pandemic created the worst recession the office sector has ever faced.”

Offices have had to adapt to remote working, and as companies return to in-person interaction, they’ll have different needs. As pointed out by Forbes, “Whereas in pre-Covid-19 days, some businesses were looking for spaces with gyms, lounge areas and meeting rooms, the demand now is for indoor air quality, touchless technologies and appropriate distancing between office cubicles.”

In order to provide the types of spaces post-COVID companies require, many properties need to be repurposed, and the investment for these updates could come from 1031. In addition to being a tool for investors to build wealth, 1031 also helps encourage the best use of real estate, and since 1031 is known to increase overall investment, it can help ensure properties that aren’t as attractive in a post-COVID world don’t languish, and can instead reach their full potential.

What the proposed changes to 1031 mean for the future

There are continued efforts by industry groups to fight these changes, and nothing is set in stone at the moment. Stakeholders passionate about 1031 can take part in campaigns to let lawmakers know their feelings about keeping the program as-is. But if the proposed changes do pass, what is likely to happen in the near future?

One potential short-term outcome is that we may see a rush to sell commercial properties by individuals looking to complete exchanges under the current rules. As Fernandez notes, “the proposal’s effective date of Dec. 31, 2022, for completed exchanges is problematic. Because an owner has 180 days to identify and exchange a property, anyone considering a like-kind exchange in 2022 would essentially need to initiate the process within the next couple of months to receive the full benefit of the traditional time frame.”

After that, exchanges can still continue, just with a greater incentive to invest at smaller amounts to ensure the gain from future sales will fall under the $500,000 cap. There may also be an increase in the use of vehicles like Delaware Statutory Trusts, as these allow investors to purchase large commercial properties with smaller individual investments.

As the nation’s most trusted 1031 Exchange Accommodator, JTC Americas can act as a Qualified Intermediary for all types of transactions, included both Forward and Reverse Exchanges and those involving a Delaware Statutory Trust. No matter what changes happen to the tax code, JTC can be an integral part of making sure your exchange is done right.

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