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As part of President Biden’s 2023 budget, the administration proposed severe restrictions on the so-called 1031 exchange.
A 1031 exchange is part of the IRS tax code that allows real estate investors to defer taxes by exchanging “similar” properties. The term “similar” refers to the nature or character of the property. These properties may only be used for business purposes or held as an investment.
The proposal would allow for the deferral of gains up to a total of $500,000 for each taxpayer ($1 million in the case of married individuals filing a joint return) per year for exchanges of properties of the same type. Any gains from exchanges of the same kind that exceed $500,000 (or $1 million in the case of married persons filing a joint return) per year would be recognized by the taxpayer in the year the taxpayer transfers the exchanged property .
Almost all properties are the same as long as the use is for business or investment purposes. For example, an apartment building can be exchanged for a warehouse, which could then be exchanged for an investment in a retirement home.
President Biden’s proposal would not only severely limit the real estate values that investors can use on an exchange, but would also be detrimental to the broader economy. While this proposal aims to generate $1.95 billion in revenue for the government by taxing the sale of real estate, what many people don’t realize is that taxes paid by companies using similar exchanges, are expected to bring in $7.8 billion for the IRS last year, according to a May 2021 study by Ernst & Young.
In addition, the proposal’s effective date of December 31, 2022 for completed exchanges is problematic. Given that an owner has 180 days to identify and exchange a property, anyone considering a similar exchange in 2022 would need to initiate the process essentially within the next few months to take full advantage of the traditional timeframe .
Some supporters of President Biden’s proposal might argue that 1031 exchanges would primarily benefit the wealthy and not hurt middle-class investors as they are unlikely to exceed the respective $500,000 and $1 million limits.
However, if the proposal is approved by the House and Senate, wealthy investors who are savvy would likely simply hold onto real estate in response — in anticipation that tax laws will change again in the future, restoring a more accommodative environment for the 1031 exchange . Their reluctance to sell property in the meantime would slow transaction volume and create an unintended domino effect within the real estate sector.
The Ernst & Young study predicted that companies connected to 1,031 exchanges would create 568,000 jobs, generate $27.5 billion in labor income and contribute $55.3 billion to GDP over the past year.
Numerous parties are involved during the 1031 exchange process, including real estate investors, escrow specialists, qualified intermediaries, lending finance firms, attorneys who negotiate agreements, Delaware Statutory Trust brokers, sponsors who prepare DSTs, and outside reporters who are accountable for aspects such as valuations, property conditions, property inspections, expert opinions and due diligence. Therefore, if exchanges are capped as President Biden is proposing, the negative impact would extend well beyond potential sellers.
Finally, small businesses – which make up 80% of businesses in the US – would also be adversely affected.
For example, if a company owns a smaller lot and wants to buy a larger lot (or lots) to allow for further growth, it might not benefit from the real estate appreciation and tax deferral that a similar type of exchange offers, thereby blocking potential business expansion.
Attempting to cap the 1031 bill tax deferral is not new. Up to this point, President Obama’s 2016 budget proposal included a limit on real estate deferrals to $1 million per year. Since Section 1031 of the tax code has not undergone a significant change since the Tax Cuts and Jobs Act in 2017, generating additional revenue for the IRS is a natural goal for the Biden administration.
In this case, however, the significant downsides of President Biden’s proposed restrictions on 1031 exchanges clearly outweigh any potential benefits.
— By Edward Fernandez, President and CEO of 1031 Crowdfunding
https://www.cnbc.com/2022/04/26/what-bidens-proposed-1031-exchange-limits-mean-for-investors-economy.html What Biden’s Proposed 1031 Stock Exchange Limits Mean for Investors and the Economy