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Section 1031 “like-kind” exchanges have long been a useful tool for family and closely held business planning. For example, business enterprises have been able to exchange commercial or industrial buildings for larger facilities without incurring current tax liability. Similarly, individuals who have owned and operated rental property but no longer are able or wish to manage such property have utilized Section 1031 to exchange their property for “net leased” replacement property, thereby obtaining a dependable stream of rental income and deferring taxation of gain on their original property. Section 1031 exchanges have sometimes facilitated avoiding taxation of such gains altogether by holding the replacement property until death, because family members inheriting such property receive a “stepped-up” basis under current law.
Prior to 2018, Section 1031 exchanges were available for a broad range of property held for business use or as an investment. The 2017 Tax Cuts and Jobs Act limited those exchanges to real property. Because of various requirements and complexity associated with Section 1031 exchanges, they are often economical only for property with substantial built-in gain.
The Biden Administration proposes to further restrict Section 1031 exchanges. The Administration’s tax proposals would terminate Section 1031 exchanges for real property gains in excess of $500,000. The Administration’s proposals also would generally eliminate the basis “step-up” on death for gains in excess of $1 million, thereby curtailing permanent nonrecognition planning as described above.
Details of the Administration’s proposed changes to Section 1031 have not yet been released. For example, it is presently unclear when the new restriction would become effective, and how it would apply where multiple properties are exchanged (e.g., whether the limitation would apply on a per-property or per-taxpayer basis – and if the latter, whether it could be mitigated by timing transfers of properties in different taxable years). Moreover, final tax legislation often differs from initial administration proposals, and the potential for such differences would appear to be magnified for the present package because the Senate is evenly divided (i.e., Administration concessions to induce passage seem likely). Nevertheless, because a $500,000 ceiling would likely render many Section 1031 exchanges uneconomical, and because it seems likely that such a restriction (if enacted) would become effective in 2022, the remainder of 2021 may represent a final opportunity for individuals, families and closely held businesses to defer substantial real property gains through such exchanges.
In practice, the complexities of Section 1031 exchanges require advance planning and coordination with multiple parties including third-party lenders and intermediaries. Because of the vagaries of the political process, the details of a final tax bill may not become clear until late in the year, by which time it may considerably be more difficult – if even possible – to structure and implement an exchange before new restrictions become effective. Thus, a proactive approach may prove valuable.
Now is an appropriate time for individuals, families and closely held businesses with appreciated real property to explore whether a Section 1031 exchange might be advantageous. Such an analysis should include consideration of all circumstances that could affect the desirability of such an exchange.