Student at Chapman University, Orange, CA
The Need for Legislative Clarity
In the last 100 years, 1031 exchanges are responsible for creating a ton of revenue, jobs, investments, and economic benefit to the nation. During his campaign, Biden stated he “wanted to completely end the 1031 exchange tax break.” While this is unlikely, it remains unclear as to how the $500,000 limit is being imposed.
- A $500,000 annual limit for each taxpayer during the year?
- A transaction limit taxing gains from any disposition exceeding $500,000?
- A $500,000 limit per year on gains from any one property?
Biden also proposed raising the long-term capital gains tax rate up to 39.6% for those earning over $1 million a year. Fewer real estate deals means less tax revenue. New York City saw a 49% decrease in commercial and residential sales in 2020, missing out on $1.2 billion in tax revenue from real estate.
In the past, significant taxation of real estate has disincentivized people from selling so many may hold off on doing so until a new administration lowers capital gains rates. Housing inventory and affordability will drop sharply. Fewer investors wanting to sell will only worsen the existing housing crisis.
It is important to understand that…
- Section 1031 is a deferral, and referring to it as a tax cut or loophole for the wealthy is misleading
- 88% of properties acquired in like-kind exchanges are eventually sold in a taxable transaction, garnering more capital gains than other properties that are bought and sold through ordinary taxable sales
- 1031 exchanges created over half a million jobs and generated more than $55 billion annually, as well as $7.8 billion in federal, state, and local taxes
- A cap on 1031s would shrink the GDP by $9.3 billion annually
Exploring Different Avenues
If 1031s become limited, we may see more investors looking towards DSTs, and investors looking to convert DST equity into shares of a real estate investment trust (REIT) via 721 exchanges. If 1031s are eliminated, one may face full taxation through a cash sale, or sell to a REIT and defer.
Investors contribute their properties to REITs in exchange for ownership shares or operating units (OP units) in the partnership. Those OP units serve as currency, and capital gains or depreciation recapture taxes may be deferred until the OP units are converted into UPREIT (umbrella partnership REIT) shares. Similar distribution rates and valuations exist between OP units and common shares, however there are differences when it comes to tax treatment and filing requirements as well as voting rights.
In a 721 exchange…
- Heirs avoid capital gains and depreciation recapture taxes
- Investors are neither confined to a 45-day window to identify a replacement nor a 180-day deadline to execute the transaction as they would be in a 1031 exchange
- You undergo a one-time tax deferral strategy, where you may no longer complete a like-kind exchange out of the UPREIT
- Taxes are owed upon the sale of REIT shares or any property contributed to the partnership
With publicly-traded REITS, shareholders may take advantage of increased liquidity and convert those shares to cash as they please. Investors should keep in mind the market is subject to volatility and that could potentially diminish returns. If a subsidiary owns properties in multiple states, they are required to file tax forms for each state a property is located in.
Even if no changes are made to Section 1031 of the IRC, many investors are becoming more aware of UPREIT transactions and may pursue 721 exchanges as a legitimate alternative to 1031 exchanges.