For commercial real estate professionals, a 1031 exchange is part of the job, but those new to the industry or new to real
estate investment may not be fully aware of what a 1031 exchange is or how it works. More importantly, the rules on 1031 exchanges may be changing. So, even if you are familiar with the process, it is valuable to check on the latest rules and to understand its potential impact on your taxes.
The 101 on 1031 exchange
1031 exchange refers to a specific tax provision that allows real estate investors to defer capital gains taxes at the time of the sale of a property. The tax rule was established for business or investment properties. It essentially allows the seller to reinvest the capital gains from the sale of one property into another real estate purchase of equal or greater value within 180 days of closing. The exchange must be between “like-kind” properties meaning that they are of the same nature or character, and it must be used for investment in a trade or business. Currently, there are no restrictions on how many 1031 exchanges can be made by one person or how often. These types of exchanges allow real estate investors to grow and develop their portfolios, while protecting them from a hefty taxes bill when they sell.
Changes on the horizon
There are many speculations about the future of 1031 exchanges with new tax proposals in the works. One part of the proposal is a $500,000 limit on deferred gains or $1 million for married joint filings within one year. This means that if someone that is single utilizes a 1031 exchange and has a gain of $700,000, they will have to pay taxes on the extra $200,000 from that deal as well as any other exchanges made within the same year. Along with limiting the amount that is allowed to be deferred, there’s a proposal to change the rate that long term capital gains are taxed at to the ordinary income tax rate for taxpayers that have an adjusted gross income over $1 million. This income tax rate will be increased to 39.6% for taxpayers filing jointly with taxable income exceeding $628,300 and single taxpayers with taxable income exceeding $523,600. These new limits on 1031 exchanges are currently proposed to go into effect for exchanges completed in tax years after December 31, 2021.
Impact on investments
These changes are still only “proposals,” leaving many investors unsure of what they should do with their current holdings. Some say they will transfer their larger real estate investments into smaller properties of $500,000 or less and others say it is time to cash out. The catch right now with starting a 1031 exchange and investing in something else is the possibility of not completing the deal before the December 31 deadline. If a deal is in process and completed even one day after the deadline, the $500,000 per year limit will be in effect and the investor will have to pay the taxes on the additional profit. Limiting the deferred gains on a 1031 exchange is seen as a way to lessen the benefits for the ultra-wealthy making large real estate investments, but the effects may trickle down to others. These changes could also possibly lead to increased rents across the country, as investors try and recoup some of their losses.
If you are considering a 1031 exchange, contact our team at Landmark Title to walk you through the commercial real estate title and escrow process.