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As part of President Biden’s budget for 2023, the administration proposed severe restrictions on so-called 1031 exchanges.
A 1031 exchange is part of the IRS tax law that allows real estate investors to defer tax by exchanging “similar” properties. The term “similar” refers to the nature or character of the property. These properties may only be used for business purposes or held as investments.
The proposal would allow deferral of gains up to a total of $ 500,000 for each taxpayer ($ 1 million in the case of married people filing a joint return) each year for the exchange of real estate of the same nature. Any gain from similar exchanges of more than $ 500,000 (or $ 1 million in the case of spouses filing a joint statement) per year will be recognized by the taxpayer in the year in which the taxpayer transfers the immovable property covered by the exchange.
Almost all real estate is uniform with each other as long as the use is for business or investment purposes. For example, an apartment building can be exchanged for a warehouse, which can then be exchanged for an investment in a senior housing.
President Biden’s proposal would not only greatly limit the property values that investors can use in an exchange, but would also have a negative impact on the overall economy. Although this proposal is intended to generate $ 1.95 billion in revenue for the government through the taxation of real estate sales, many people are not aware that paid taxes and related to companies using similar exchanges were already expected to produce 7 , $ 8 billion to the IRS last year, according to a May 2021 study by Ernst & Young.
In addition, the date of entry into force of the proposal 31 December 2022 for completed exchanges is problematic. Because an owner has 180 days to identify and exchange a property, anyone considering a similar exchange in 2022 will essentially have to initiate the process within the next few months to get the full benefit of the traditional time frame.
Some proponents of President Biden’s proposal might argue that 1031 exchanges primarily benefit the wealthy, and that would not affect middle-class investors because they are unlikely to exceed the respective limits of $ 500,000 and $ 1 million.
But if the proposal is approved by the House of Representatives and the Senate, wealthy investors who are savvy will probably just stick to real estate in response – and expect the tax law to change again in the future and restore a more expansive environment for 1,031 exchanges. Their reluctance to sell property in the meantime would slow down transaction volume and create an unintended ripple effect in the real estate sector.
The Ernst & Young study expected companies related to 1,031 exchanges to produce 568,000 jobs, create $ 27.5 billion in labor income and add $ 55.3 billion to GDP over the last year.
There are several parties involved in the entire 1031 exchange process, including real estate investors, escrow specialists, qualified intermediaries, lending finance companies, bargaining lawyers, Delaware Statutory Trust brokers, sponsors setting up DSTs and third party reporting professionals in charge of aspects . such as valuations, property relations, property control, investigations and due diligence. As a result, if exchanges are limited, as President Biden suggests, the negative impact will extend far beyond potential sellers.
Finally, small businesses – which make up 80% of businesses in the United States – will also be negatively impacted.
For example, if a company owns a smaller property and wants to buy a larger one (or several properties) to allow for continued growth, it will not be able to take advantage of the increase in property value and the tax deferral from a similar type of exchange, which halting potential business expansion.
Attempts to limit the deferral of 1031 exchange tax are not new. To that point, President Obama’s 2016 budget proposal limited the deferral of real estate to $ 1 million annually. Since section 1031 of the Tax Act has not seen a major change since the Tax Cuts and Jobs Act in 2017, it is a natural goal for the Biden administration to generate additional revenue for the IRS.
But in this case, the widespread disadvantages of President Biden’s proposed limits for 1,031 exchanges clearly outweigh all possible benefits.
– By Edward Fernandez, President and CEO of 1031 Crowdfunding