As part of Douglas Elliman’s commitment to market data and market research, Sophia Song offers “Elliman Insights” as a platform to provide useful and relevant data along with the translation of how to use and apply such data.
This post offers her heads up on possible changes to 1031 exchange rules proposed for Obama’s 2017 budget as well as a recommendation to those who may be considering utilizing a 1031 exchange, to get the deal done before the end of 2016.
THE NEWS:
Potential changes to 1031 exchange rules may be of concern to buyers and sellers of investment properties.
THE BREAKDOWN:
The 2017 Budget may include some major changes to 1031 exchanges. This can have a major impact for real estate investors, commercial real estate and potentially the economy too. Since this issue is likely to come up a fair amount before the end of the year, I figured it would be useful to know what’s at stake.
First, a quick refresher: What is a 1031 exchange? 1031 exchanges allow sellers who make a profit on the sale of their property to defer having to pay capital gains taxes by allowing them to invest the profit into another property that is “like kind” (meaning physical property for physical property).
I spoke with Ace Watanasuparp, VP and regional manager at Citizens Bank’s Home Lending Solutions. He gave me some more detail on the different types of 1031 exchanges that buyers and investors use:
Delayed Exchange: This allows investors to sell their investment property first and then find a replacement property. This is typically the most common type of 1031exchange agents will encounter.
Construction/Improvement Exchange: If the investor ends up purchasing a property that is less than the value of the previous sold property, they are able to do construction to the new subject property so that the value is equal to or greater than what the previous property was sold for to be compliant with the 1031 Exchange rules.
Reverse Exchange: This is when the investor would purchase the next property all cash, however title cannot be under the investor’s personal name, as the investor cannot be on the title to the replacement property and the previous sold property. Best to set up an LLC for this type of transition.
Simultaneous Exchange: This transaction requires two parties to exchange their properties with one another. This is fairly uncommon practice today as the odds of finding a party where both are equally interested in the exchange are few and far between.
Some important caveats about 1031 exchanges: The next investment purchase must be equal to or greater than the amount of what the property was sold for (i.e.: If the property was sold for $1,300,000 the next investment purchase must be $1,300,000+), the investor has 45 calendar days to identify the next proposed investment property, and that the property must be acquired within 180 days. Funds can never be in possession of the actual investor’s personal name; the transfer should pass through either by a Limited Liability Corporation or through a 1031 Exchange attorney. If the investor ever had possession of the funds in their own name, the funds are then “realized” and are now susceptible to capital gains tax.
So, now that we all know the different types of 1031 exchanges, here’s how they may change: President Obama’s proposed FY2017 budget recommends limiting like-kind exchanges to $1 million annual gain deferral—excluding art and collectables—used for investment eligibility. There is also talk in Congress about limiting the amount of the 1031 Exchange further or eliminating the program completely.
The feeling amongst those who want to reform or repeal this program is that 1031 exchanges are essentially a tax dodge for the wealthy and offers little benefit to the middle class.
THE INSIGHTS:
Those who want to keep the 1031 exchange the way it is— which is many in the real estate industry— argue that reform or repeal could have a major impact. In fact, a study by Ernst & Young late last year suggested that there may be far reaching implications if 1031 exchanges are repealed including:
Discouraging investment Increased reliance on debt financing as it becomes less expensive than equity financing, as businesses would pay tax upon sale Increased holding periods of assets by 20% or more under a repeal negative impact on the overall economy, shrinking the economy by $8.1 billion over the long term with an unfair concentration of certain industries
So, a big deal and bad news, particularly for real estate.
WHAT AGENTS SHOULD BE MINDFUL OF: When it comes to the 1031 exchanges, timing is always critical and now even more so with the looming 2017 budget proposal and the uncertainty surrounding it. If you have clients who may be considering utilizing a 1031 exchange, advise them to get the deal done before the end of 2016.
LIKELIHOOD OF 1031 REFORM OR REPEAL: This is merely a proposal and not a done deal. In an election year with the President and Congress not always in agreement—to put it mildly— any reform at all may look quite different than what is now currently being proposed. Not surprisingly, there is a strong lobby pushing to keep 1031 exchanges as they currently stand. For example, just last month, the Investment Program Association brought 150 executives to Capitol Hill to discuss the issue with lawmakers. With not only the White House, but many House and Senate seats at stake, it is likely that 1031 exchanges will become a hot button issue as the budget process goes on.
BOTTOM LINE: It’s good to be prepared and keep clients updated on this situation and the timing.
