It could be limited, but there’s still an opportunity for families or businesses holding multiple properties even if they aren’t currently trying to sell.
The Biden tax plan has a price tag — about $4 trillion. The money will come from raising taxes on corporations and the wealthy as well as eliminating various tax breaks.
1031 exchanges, which allow investors to buy and sell the property without paying tax on capital gains, would be significantly limited. This tax break lets investors defer taxes over and over until their deaths. They can then leave these assets to their heirs, often with no capital gains tax due. 1031 exchanges comprise approximately 6 percent of U.S. commercial real estate sales volume. They cost the Treasury $4-6 billion annually.
The proposed change targets large property investors who benefit from the current 1031 exchange like-kind rules. They stand to pay much higher capital gains tax. The change won’t affect smaller investors, as the provision applies only to gains over $500,000 (or $1,000,000 for married couples).
Whether President Biden and the Democrats can pass their tax bill via reconciliation remains to be seen. In the meantime, there’s a planning opportunity for family groups or partnerships that hold multiple properties.
The Value of Basis Swaps for Long-Range Sale Planning – You Don’t Have Current Plans to Sell
If your family owns properties individually and through various entities including partnerships and trusts, and you’re not planning to sell in the short-term, you can still benefit from a 1031 exchange. Related parties can make 1031 exchanges among themselves as long as they hold the-properties for two years.
For example, an individual recently purchased a rental building, with a high tax basis. The family also owns timber land with a rental house in a trust with a very low tax basis. The family knows that it will likely sell the timber property before the new rental building. The family enters into 1031 exchange and swaps the two properties; the trust takes the new rental building and the individual takes the timber land. The timber land, which previously had a low tax basis, now has a high basis. The family can sell the timber property after two years and incur minimal capital gains tax.
This strategy allows families to look in the future and plan based on which properties they intend to hold long term.
The “Like-Kind” Definition Gives You Flexibility
A common misconception holds that like-kind properties must be the same size or type to qualify for a 1031 exchange. Primary residences don’t qualify, but the IRS allows the exchange of different types of assets. The properties must be of equivalent value. You can swap a mixed-use development for an industrial plant, for example, or vacant land for a strip mall.
The IRS views most swaps as sales and taxes accordingly, unless the swap qualifies for a 1031 exchange. In that case, either no tax or limited tax will be due, which means your investments grow on a tax-deferred basis. Until the rule is eliminated or limited, you can make these like-kind exchanges as often as you choose. Rolling your gains over on a repeated basis defers tax on profits until the property is liquidated.
At that point, the trust or partnership will have to pay tax at a long-term capital gains rate, which varies depending on income.
Basis Steps Up — Tax on Appreciation is Eliminated – a Huge Value as Long as it is Available
The 1031 exchange lets you use existing tax law to your advantage. When an older family member passes, the basis on their holdings is stepped up to fair market value and appreciation for tax purposes goes away. This reduces or eliminates capital gains tax. The beneficiaries can immediately sell and pay no capital gains tax. This step-up benefit is also at risk of being eliminated or limited.
The ability to leave investment properties to a younger generation without adverse tax consequences is significant. Consider this example:
A high net worth individual acquires a property in 2000 for $1 million. In 2019, this individual sells the property for $6 million, and leaves the proceeds in cash. He incurs tax on a $5 million gain. He then passes away in 2020.
Using a 1031 exchange, this individual could have sold the property for $6 million in 2019 and acquired a new property for $6 million, rather than keeping the cash. At the time of his death, the new property is part of his gross estate, so its basis is stepped up to the fair market value of $6 million If the estate or beneficiaries sell the property for $6 million, they pay no capital gains tax.
This 1031 exchange strategy saves the estate capital gains tax on $5 million.
Planning and Timing are Critical
You should consult your tax and estate planning advisors before completing a 1031 exchange and be mindful of certain considerations. The trustee has a fiduciary responsibility to ensure that swapped properties are of equivalent value. An appraisal or business valuation must confirm both values. The exchange must not change the economic position of the trust beneficiaries, for better or worse.
Given the timing on 1031 exchanges, we recommend an in-depth meeting with you, your legal counsel and wealth management advisors. Once you’ve closed on a relinquished property, you have 45 days to identify a potential replacement property and 180 days to acquire it.
Our experience with 1031 exchanges, plus our wealth management and estate planning tax services, make us well-suited for your needs. To discuss the best way forward, contact Brent Wilkinson or your Windham Brannon professional.
