New limits are considered for Sec. 1031 transactions.

Financial and investment advisers should seek to understand the implications of a legislative proposal originally set forth in the American Families Plan that would severely limit benefits historically provided by Sec. 1031 of the Internal Revenue Code. Under the proposal, the deferral of capital gains from the exchange of real property used in a trade or business, or of investment property, would be limited to $500,000 ($1 million for married individuals filing jointly). At the time of this writing, Congress is actively considering major tax legislation that may include such a limitation on Sec. 1031 exchanges.

The discussion below summarizes the changes proposed that would affect deferral of capital gains and depreciation recapture related to exchanges of like-kind real property. As will be seen, investors would experience a significant loss of tax benefit from carrying out such an exchange if the White House proposal is enacted.

 

TIME TO CASH OUT

With housing prices at all-time highs, interest rates at all-time lows, and an ever-shrinking inventory of available homes, real estate owners may be considering whether to cash out or leverage equity, given the current economic climate as this is being written. According to the National Association of Realtors, median home prices in September 2021 were up 13.3% compared with the same time a year earlier (NAR, Summary of September 2021 Existing Home Sales Statistics). Meanwhile, interest rates on 30-year fixed-rate mortgages have remained flat at an attractive rate of just above 3% on average. Investors who have experienced appreciation in the current strong real estate market might consider selling their property while housing prices are at market highs, which for many would mean recognizing capital gains. Alternatively, property owners might want to capitalize on increased appreciation by reinvesting in other income-producing properties. Tax professionals and trusted advisers should be prepared to educate their clients regarding the potential tax consequences of sale or reinvestment decisions.

Sec. 1031 provides for the deferral of capital gains on the exchange of property held for productive use in a trade or business, or for investment, for replacement property that is also held for productive use in a trade or business or for investment purposes (Regs. Sec. 1.1031(k)-1(a)). In other words, an investor can exchange one investment property for another investment property without triggering a taxable event, assuming the rules of Sec. 1031 are properly applied.

Sec. 1031 also provides for the deferral of depreciation recapture, currently taxed at a flat rate of 25% upon sale of an investment property. If an asset has been held and depreciated over a long period of time, depreciation recapture can be a huge consideration in the sale/reinvestment decision, since the tax owed on recaptured depreciation may be as much as or greater than the overall capital gains tax. Deferral of taxation in a reinvestment situation is in keeping with a long-held sentiment that taxes should be collected when taxpayers have the wherewithal to pay. If the proceeds from the sale of an investment property are being reinvested, the taxpayer may not have the wherewithal to pay income taxes.

President Joe Biden has proposed numerous changes to the tax code that would significantly affect investors who are making the sale/reinvestment decision. As of this writing, Congress is considering major tax reform, and one of the many proposed changes is a limitation on the amount of gain that may be deferred in a reinvestment situation. Specifically, Biden has proposed limiting capital gain deferral in a like-kind exchange to a maximum of $500,000 ($1 million for married individuals filing a joint return). The American Families Plan further proposes to tax long-term capital gains as ordinary income at a rate of 39.6% for higher-income earners, compared with the maximum long-term capital gains rate today of 23.8% for high-income earners (20% long-term capital gains rate plus 3.8% net investment income tax). Under the American Families Plan, when the 3.8% net investment income tax is added to the proposed maximum long-term capital gains rate, high-income earners would pay as much as 43.4% on long-term capital gains. Although the details of the proposed changes are still taking shape as of this writing, increased taxes are expected on both earned and capital income.