President Biden’s Tax Proposal Includes
Limits to Section 1031 Exchanges
In the recently issued Fiscal Year 2022 Budget and Treasury Green Book, President Biden outlined details for a proposed limitation to Internal Revenue Code Section 1031 exchanges, also commonly referred to as “like-kind” exchanges. In the proposal, 1031 exchanges would be limited to deferring taxable gains of up to $500,000 for each taxpayer, or $1,000,000 for married taxpayers filing a joint return, each year.
Section 1031 is a way for taxpayers to defer capital gains tax on the sale of certain property if they reinvest the proceeds in other like-kind property. Under current law, there is no cap on the amount a taxpayer can defer in any given year. Absent qualifying as a 1031 exchange, the transfer of one property in exchange for another property produces the same tax consequences as an outright sale, where taxes would be owed for any realized gain.
In order for an exchange to qualify under Section 1031, both the property being sold (referred to as the “relinquished property”) and the property being purchased (referred to as the “replacement property”) must be held for use in a trade or business or for investment. The definition of like-kind property for purposes of Section 1031 is very liberal, as most real estate will be like-kind to other real estate.
The timeline of a 1031 exchange is crucial, as each step in the process must meet specific deadlines. Once the relinquished property is sold, an investor has 45 days to identify potential replacement properties. Thereafter, the investor must close on one of those identified properties within 180 days from the relinquished property’s sale date. It is important to note that the sale proceeds from the relinquished property must be held by a qualified intermediary, until those proceeds can be applied to the purchase of the replacement property.
By way of example, assume an investor currently owns a 100-acre farm that he purchased for $200,000, and is currently worth $1,000,000. He decides he wants to sell the 100-acre farm and purchase a residential apartment building valued at $1,000,000. Under a 1031 exchange, this investor could exchange his 100-acre farm for the residential apartment building and defer recognizing his $800,000 gain ($1,000,000 – $200,000). Absent qualifying as a 1031 exchange, this investor would owe tax at capital gains rates at the time of the sale on the $800,000 gain. Under President Biden’s proposal, assuming this same investor is a single filer on his tax return, he would be limited to deferring $500,000 of his gain and required to immediately recognize $300,000 as taxable gain on the sale ($800,000 – $500,000).
Although just a proposal at this point, real estate owners and investors should take notice of this potential limitation for future 1031 exchanges. FGKS Law provides 1031 exchange services and routinely assists clients with these types of transactions. We will continue to monitor this proposal and any further developments that may occur. In the meantime, if you have any questions pertaining to a possible 1031 exchange, please reach out to one of the tax attorneys at FGKS Law: Craig Albers (calbers@fgks-law.com), Phil Borger (pborger@fgks-law.com), or Dan Bensman (dbensman@fgks-law.com).
