If Joe Biden becomes President, he has vowed to raise taxes on the rich and businesses and pledged to slaughter a commercial real estate sacred cow: the 1031 exchange (a.k.a “like-kind exchange”).
Here’s a brief summary of the Biden tax plan:
- Raise the top income tax rate from 37% to 39.6%.
- Raise the top corporate income tax rate from 21% to 28%.
- Eliminate tax-deferred “like-kind” real estate transfers.
- Tax capital gains and dividends at ordinary rates (for those with annual incomes over $1 million).
- Tax unrealized capital gains at death.
- Impose a 15% minimum income tax on large companies.
Whether you agree with Biden’s tax plan or not; if you own commercial real estate that you plan on selling or otherwise disposing of in the near future, you might want to accelerate that process in case the election results don’t work in favor of the continued viability of tax-deferred 1031 exchanges.
Better to err on the side of caution in this situation. If you decide to accelerate your 1031 exchange, in the worst case, if the election results in preserving the 1031 exchange, you may not have gotten the highest price on your property because you jumped the gun a little.
Consider the alternative. If you take a wait-and-see approach and the 1031 exchange is eliminated, when you go to sell your commercial property, you’ll be stuck with a tax bill that you could have at least delayed (maybe even avoided if the 1031 Exchange is brought back from a future regime change) – especially if you’re a million-dollar earner.
So, instead of deferring tax, you’ll be stuck with a tax bill on the gains from the sale at the highest ordinary rate (remember that capital gains are now taxed at the highest rate for those with an income of $1 M and above). For example, a sale yielding $1 M in gains will result in a whopping tax bill of $396,000 under the new tax regime.
Let me reiterate. DON’T PANIC!
If you need to carry out a 1031 exchange in short order, let me offer you some tips. First, I think it’s useful to look at the tax provision itself.
Section 1031 of the Internal Revenue Code (Tax Code) provides that an investor can defer capital gains from the sale of a productive real estate or business asset by “exchanging” it for “like-kind” property provided certain IRS rules are met.
Currently, there are no limits to the number of times an investor can take advantage of the 1031 rule (swap ‘til you drop).
Here is a summary of the most important points of a qualifying 1031 exchange:
- The property must be exchanged for “like-kind” property. Commercial real estate is the most common type of property exchanged.
- A third-party intermediary is required to execute the exchange.
- 45 days to identify replacement property.
- 180 days to replace the relinquished exchange property.
- The price of the replacement property must be equal to or greater than the equity in the old property plus an outstanding debt.
Don’t Forget the Clock is Ticking
Timing is crucial in qualifying for 1031 treatment. The 45-day rule for identifying the replacement property and the 180-day rule to finalize the exchange are the most critical.
A 1031 exchange can be either simultaneous or deferred, with a deferred exchange being the most common by far – for its flexibility.
In a deferred exchange, an investor can sell an existing property but is not required to find and close on a replacement property until later. Think 45-day and 180-day rules.
In a deferred exchange, the investor must use a qualified intermediary to act as an agent for holding net proceeds from the relinquished property before they are reinvested in the replacement property.
Misconceptions about what constitutes like-kind property are the biggest because of the anxiety for owners of commercial property contemplating a 1031 exchange. What if I can’t find a like-kind property in time? That’s the biggest concern.
Many investors believe that like-kind property must be of the same type, be in the same geographic location, and be held through the same ownership structure in order to satisfy the 1031 exchange requirements. This is a common misconception.
In fact, not only does the property not have to be the exact same type in the exact same location, but you can also exchange for multiple properties or even swap into a co-ownership situation with other investors. Knowing this will expand your options and allow you to find a replacement property fast and close on that property within the required time frames.
The most important thing to remember with a 1031 exchange is that the main criteria for establishing like-kind property are that both properties in the exchange must be held for productive use in a trade or business.
Based on that definition, there is no requirement that the properties be of the same type, be in the same location, etc. In fact, the IRS has been pretty liberal in determining what qualifies as like-kind property.
The following non-comprehensive list of real estate assets would qualify as like-kind property:
- Unimproved property
- Vacant land
- Net-lease property
- Commercial buildings
- Rental properties
- Farms or ranches
- Resort property
- Industrial property
- Retail property
- Office buildings
- Self-storage facilities
- Senior-living centers
- Hotels or motels
As you can see, the possibilities are almost endless and there are no geographic requirements other than that the properties be located in the United States.
Exchanging property for property in a co-ownership situation is allowable in two circumstances: property held through a DST (Delaware Statutory Trust) and through a TIC (Tenancy-in-Common).
The overwhelming advantage of exchanging into properties held in a DST is the opportunity to invest in a portfolio of properties instead of just one to diversify risk and insulate income. And just like investing in a private equity real estate fund or real estate syndication, you can invest headache-free by leveraging the expertise of others and letting someone else deal with the day-to-day management of this portfolio.
The major disadvantage of DST’s cited by many investors is illiquidity. Most DSTs have long investment windows of five or more years, so be prepared to relinquish control for the long run.
Although considered a disadvantage by many, this same illiquidity is what shields DST and other private investments from broader market volatility.
Like DSTs, TICs also allow for greater diversification of your investment portfolio. Fractional or co-ownership interests in real estate through TICs allow you to acquire, together with other investors (no more than 35 co-owners), a larger, potentially more stable, secure and profitable real property asset than what you could have acquired and afforded on your own.
The one most cited drawback of TICs is personal liability. Because all co-owners must be named on the title and must be listed as a co-borrower on any mortgage on the acquired property, each co-owner can potentially be held responsible for the full outstanding amount of the mortgage as well as for any potential property-related liabilities like personal injury and hazardous wastes.
If you want to hedge your bets on the outcome of the election and the possible elimination of the 1031 exchange, don’t stress. Remember all your options including the wide range of properties that would qualify as like-kind property available to you.
Don’t forget to explore the types of co-ownership options that would allow for more diversification and insulation from downturns. Lastly, don’t forget the fundamentals.
You want your replacement property to make economic sense. No point in deferring capital gains if the property you exchange into performs poorly financially.
In fact, many investors take advantage of the 1031 exchange to exchange into properties that perform better financially in better-performing regions and cities. That’s why many investors on the coasts are swapping into secondary markets in the midwest where cap rates are higher and overall returns are superior due to steady in-migration of jobs and workers.
Keep your options open to meet your deadlines and to potentially swap into a better financial situation.
Look beyond your current market.
Don’t limit yourself to local markets. Look beyond your backyard to expand the pool of potential like-kind property that you can exchange into. To have more options, reach out to brokers, contacts, people in your professional network, etc. in attractive markets outside your home state.