Potential Changes to Section 1031 Under Biden
Now that President Biden is in office and both chambers of Congress are controlled by Democrats, some big changes to the tax code may be coming to the commercial real estate market. In particular, changes may be made to Section 1031 of the Internal Revenue Code. 1031 property exchanges, also called Starker exchanges or like-kind exchanges, may soon get the ax. While no changes have been made yet, the information below is based on Biden’s policy proposals and official reports from members of the administration.
Introduced 1031 Exchange Changes
Biden has introduced a policy proposal called “The Biden Plan for Mobilizing American Talent and Heart to Create a 21st Century Caregiving and Education Workforce,” which may eliminate the 1031 exchange option for real estate investors who earn more than $400,000 per year.
Currently, the 1031 exchange program allows real estate investors to defer federal capital gains taxes on the sale of a business or investment property when the proceeds of the sale are immediately reinvested into the purchase of like-kind property. The only rules that apply are regarding the timeline of the exchange, the value and type of the properties involved, and the required use of a qualified intermediary. If the relinquished property has a higher value than the replacement property or properties, capital gains taxes must be paid on the difference, called the boot.
However, Biden campaign officials have said that his policy proposal aims to eliminate these exchanges for high-income investors, with the proposal citing a funding plan of “rolling back unproductive and unequal tax breaks for real estate investors with incomes over $400,000” and using that capital gains tax revenue to fund his plan.
Eliminating this tax deferment method for high-income investors may cause them to hold on to properties for longer than they otherwise would have, which will likely have a trickle-down effect of decreasing supply and demand for business and investment real estate properties. Lower-income investors may still be able to make 1031 exchanges in the same way as is currently allowed.
Other Potential Changes
Beyond eliminating section 1031 exchange options for high-income real estate investors, the Biden administration also proposes to potentially eliminate or mitigate asset step-up when the owner of a 1031 exchange property dies without ever having paid capital gains taxes. This is currently a loophole through which investors can defer paying capital gains taxes indefinitely, leave the properties to their next of kin, and have the due capital gains tax amount essentially go away.
Capital gains tax rates may also be increased, according to official reports. Rates may be increased to as high as 39.6% from the current maximum of 20%. Long-term capital gains may be taxed at this new higher rate for investors whose taxable income is greater than $1 million per year.
Biden has also pledged to reduce the carbon footprint of US buildings by 50% before 2035. New national building energy performance standards will be introduced by the Department of Commerce to strengthen rules for building appliances and equipment, which may have an impact on the commercial real estate market.
What If There Are No Changes?
Even if no changes are made, it’s likely that there will be an uptick in 1031 exchanges in the coming year, solely due to the amount of speculation that the program may be repealed. But, it’s likely that at least some kind of changes will be coming down the pipeline.
Section 1031 exchanges must happen at the entity level in the context of a partnership. There is an opportunity to plan ahead to avoid partnership classification, however, which would instead result in direct, partial ownership. That means that some high-income investors may still be able to make like-kind exchanges even when the other owners retain their interests.
To conduct a like-kind exchange, it’s generally necessary to qualify as an investment, which means that single-family rental houses, apartment buildings, and duplexes will qualify whereas a hotel or motel would not.
What is FAQ?
If the program is eliminated or changed dramatically, other questions will certainly arise, such as: Will there be a phase-out program for high-income investors? Will the realty gain affect the $400,000 cap? How will related-party rules impact the new restrictions? Will the income of C corporations affect the result of the new rules? Will investors be allowed to control the earnings of a C corporation in order to use that entity to avoid the higher taxes?
The Biden policy proposal also includes an increase in the C corporation tax rate up to 28%. In all likelihood, reality will remain outside of the corporate solution to avoid double-taxation problems that can arise with C corporations.
If Biden does end up changing Section 1031, chances are high that there will subsequently be more emphasis on installment reporting. Investors might also decide to gift real estate to family members more frequently, in order to spread out the gain over multiple people who are in lower tax brackets.
There may also be an increase in charitable gifting of real estate. If step-up at death isn’t repealed, that will provide an added incentive for investors to retain properties until they die instead of performing additional like-kind exchanges.
Increased capital gains tax rates may have a positive result on qualified opportunity funds, which encourage investment in economically disadvantaged regions. In 2021, realized capital gains that are reinvested in qualified opportunity funds within 180 days should still qualify for 10% gain forgiveness after five years, deferral of the gain until 2027, and no gains taxation on the investment itself if the investor holds it for at least ten years.
The Biden administration has proposed limiting the scope of 1031 exchanges, eliminating the opportunity for investors who earn over $400,000 of taxable income per year. There is also the chance that the entire program might be eliminated. Tax-free treatment of investment exchanges may also be dramatically reduced in the near future as part of Biden’s tax-increasing legislation.