Real estate investors are keeping an eye on Washington after the Biden administration proposed a change to Section 1031 of the Internal Revenue Service (IRS) tax code. The proposed change is intended to increase taxes on the mega-wealthy, but there could be an impact on anyone who buys and sells investment properties.
Whether you dabble in real estate investments or have a large portfolio of properties, you should know how a change to the 1031 exchange could impact you and your bottom dollar.
What is the 1031 exchange?
For more than 100 years, savvy investors have been able to defer paying taxes on capital gains from property sales by using a 1031 exchange.
Say you purchased a ranch for $1 million and sold it today for $2 million. If you roll-over the $1 million of earnings into another investment property, such as an apartment complex or office building, within six months, you can defer paying taxes on your gains.
At present, there is no time limit to how long or how often the 1031 exchange can be used. That means you could defer paying taxes on your capital gains for the rest of your life as long as you keep investing the profits.
The code also forgives deferred taxes upon death, meaning your heirs would not be on the hook to pay your deferred taxes.
How could the new policy change the 1031 exchange?
Under the proposed changes to 1031, individuals and couples will be limited on the amount of taxes they can defer on capital gains. Individuals will be able to defer paying taxes on gains of up to $500,000, and married couples can defer on up to $1 million.
In addition, the policy change would not forgive deferred taxes on capital gains upon death. That means anyone who inherits your property will be responsible for paying the deferred taxes, as well as taxes on any additional gains when the property sells.
At present, the proposed change is just that: a proposed change. The 1031 exchange has been targeted in previous updates to the tax code. In 2017, other parts of the 1031 exchange involving art investments were changed.
Should the proposed change go through, there are some steps you can take to prepare.
How can you prepare your investments?
If you currently own investment properties with capital gains valued above the proposed threshold, now may be a good time to sell and reinvest with the full benefits of a 1031 exchange. The proposed plan will not be retroactive or go into effect until 2022. That means, any 1031 exchange you complete before December 31, 2021, will not be impacted by the change.
There are some caveats to keep in mind. The first is that the exchange needs to be completed by the end of the year. That means you would need to complete the sale of your property and complete the purchase of another property using those profits on a tight deadline.
Also, the sale and purchase must be like-kind. There is quite a bit of flexibility when it comes to like-kind. You can sell land and purchase a building and vice versa. However, you are not able to use the 1031 exchange on other investments, such as stocks and art, into real estate.
As with any real estate investment, you want to make sure that now is the right time to sell an investment property. If your current holdings have gained in value above the $500,000 threshold for an individual or $1 million for a couple, now could be the time to sell for an exchange. If your property has held in the purchase value, or depreciated, you may not see any benefit from completing a 1031 exchange at this time. In those cases, selling may not be your best option.
The good news is that in summer 2021, the real estate market remains hot for sellers. Stay-at-home orders and community restrictions are lifting, and there have never been more tools and resources to sell your property online than now, such as virtual tools, giving you plenty of options to buy and sell.
Even if you decide to hold onto your property, there are ways to build your real estate’s value for both short- and long-term investments.
One way to develop your portfolio is to use your property in a new way. For example, you could convert a building into multiple offices or multiple-family homes and earn rental income in addition to property appreciation. You could develop a piece of land and turn it into office suites or a new residential neighborhood and sell them individually. There are multiple options available for developing land, so do your research to find what works best for you.
Some investors may also consider selling smaller pieces of their property over time and reinvesting those proceeds through a 1031 exchange. Consult with a local real estate agent, either full-service or low commission, who specializes in 1031 to find out how you can get the most bang for your buck.
What can you do if you are new to real estate investments and still want to benefit from a 1031 exchange?
If you are in the process of building your real estate investment portfolio or are looking to start one, there are lower-stakes options available that still give you the benefits of a 1031 exchange. A Delaware Statutory Trust (DST) enables multiple investors to jointly own property. A sponsoring company collects each investor’s money and handles the daily operations of sales and rent.
In turn, DST investors regularly receive payments during the trust’s agreement. Most DSTs run for five to 10 years. With smaller gains, you are still eligible for tax breaks by investing your income into new properties over time.
Find out if a DST is right for you by checking with trusted brokerages and sponsors.
Right now, it is still too soon to tell whether or not the proposed changes to Section 1031 will go through. Though the future of the 1031 exchange remains unknown, you still have plenty of options to build your net wealth through real estate by being an adaptable investor.