Biden’s Green Paper was published on May 28, 2021 and provided further details and effective dates on his tax proposals. While many believed that wealthy taxpayers would be targeted to pay additional taxes, the limitation of similar exchanges, coupled with increased tax rates on long-term capital gains, could skyrocket the tax burden for high-income real estate professionals in 2022.
Commercial real estate
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Exchanges of the same kind, also known as 1031 exchanges, have been included in the Tax Code since 1921 and allow taxpayers to exchange similar property and defer recognition of profits. The rationale for deferring profit is that a taxpayer participating in the stock exchange merely changes his investment vehicle. Due to the provision mechanisms, the taxpayer’s profit that would have been recognized had the property been sold in full is embedded in the property received. In other words, the increase in value on the stock exchange is not eliminated, but merely postponed to a later point in time when the taxpayer finally sells the property received in exchange.
For an exchange to qualify under 1031, an exchange of property held for productive use in a trade or business, or for investment, must be in place solely for property of the same type held either for productive use in a trade or business or for investments. Property that cannot be exchanged under 1031 includes stocks, bonds, debentures and partial holdings in partnerships. In addition, any property exchanged must be of the same type. The definition of similar property is extremely liberal after 1031. For example, an exchange of commercial property for a ranch or farm is considered an exchange of property of the same type. Because of the broad definition of property of the same type, real estate professionals have used this provision to diversify their holdings and defer taxable profits from the sale of property.
Let’s take a simple example. For example, suppose Larry has an investment in a ranch. He bought the ranch for $ 200,000 and it’s now worth $ 1,000,000. Larry has decided that he no longer wants the ranch property as an investment and wants to buy an apartment building in Chicago. Larry identifies a Mary apartment building in Chicago with an FMV of $ 1,000,000. Larry can trade his ranch for the Chicago apartment building and postpone recognition of the $ 800,000 (1,000,000-200,000) win using the same exchange rules. Larry’s base in the Chicago apartment building will match his $ 200,000 base on the ranch. Therefore, if Larry sells the apartment building in the future, the deferred profit will be recognized.
Biden’s limit of 1031 exchanges
President Biden isn’t the first government to try to limit 1,031 exchanges. The Tax Cut and Jobs Act, passed in December 2017 under the Trump administration, significantly changed 1031 exchanges by excluding personal-specific personal property and intangible property from the forbearance calculation. President Biden’s proposal would still allow 1,031 real estate exchanges, but minimize the benefits to only allow a $ 500,000 per year deferral, or $ 1 million when filing a joint declaration for spouses. Assuming Larry is single in our example above, only $ 500,000 of profit could be deferred on Biden’s proposal and Larry would have to declare $ 300,000 in capital gain on his tax return.
Now, some readers may argue that this is still a lot, especially since the $ 300,000 in recognized income could be taxed at preferred long-term capital gains rates that, under applicable law, do not exceed 23.8%. But not so fast. President Biden’s Green Paper also suggests that long-term capital gains for taxpayers with adjusted gross income greater than $ 1 million should be taxed at the ordinary income tax rate. In addition, the Green Paper also increases the highest ordinary income tax rate from 37% to 39.6% for married joint taxpayers with taxable income above $ 628,300 and for single taxpayers with taxable income above $ 523,600. Under current law, Larry’s transaction would not result in any state or federal income tax. But, following Biden’s suggestion, Larry could now have a federal income tax liability of $ 130,200 when the normal income tax rate and net investment tax ((39.6% + 3.9%) x $ 300,000) are factored in. In addition, the recording of income at the federal level could possibly trigger additional state income taxes.
Biden’s 1031 change effective date
As you can imagine, completing a like-for-like exchange is not an easy undertaking as it can take a considerable amount of time to both identify like-type property and complete the transaction. In addition, a direct exchange is not always practical as the two parties involved may not have property in which the exchanging party is interested. Hence, a taxpayer can hire a qualified intermediary who will give the taxpayer more time to identify the property they want. There is a strict 180 day policy for identifying and exchanging 1031 properties. If a taxpayer does not complete the transaction within 180 days, the profit is recognized and included in taxable income. A taxpayer interested in a like-for-like swap has 45 days to identify potential replacement properties once the transfer of their abandoned property is complete. The exchanger also has 180 days from the date on which they gave up their property to purchase replacement property.
It’s not uncommon for taxpayers entering a 1031 exchange to use the full 180 day rule before closing the transaction. The administration has proposed an entry into force for the limited deferral provision of 1031 for exchanges completed in tax years after December 31, 2021. Focus on that word completed. The careless taxpayer who participates in a 1031-like exchange on or after July 5, 2021 and has just taken the entire 180 days to complete the transaction completed their 1031 transaction in tax year 2002. This way, if the 1031 proposed amendments to the Green Paper are implemented, the taxpayer has capped the deferral amount on its conversion to $ 500,000 ($ 1,000,000 for married depositaries) .
So what now?
High net worth real estate professionals should carefully monitor potential federal tax reform. In addition, the use of tenancy-in-common arrangements should be considered when looking to invest in new real estate businesses. This is an arrangement in which two or more people share ownership of a piece of land or property. This could help limit the profit realized on a future deferral of 1031 to ensure it falls below the USD 500,000 deferral limit.
One thing is for sure, federal income tax planning won’t get any easier when another major U.S. federal tax package is passed in December 2021. Many practitioners are still struggling with the impact of the TCJA on their tax planning strategies. The changes to the federal tax law, however, have become more political and, at this point in time, could change every four years, depending on the president and the party that controls Congress. For now, keep your wallets as the federal government is trying to get more of your money and there is a good chance your accountant will do the same!