A change to the 1031 exchange is proposed in the Administration’s Fiscal Year 2015 Revenue Proposals to be effective for all like-kind exchanges completed after December 31, 2014. On page 102 of the 297 page budget proposal, the modification to the 1031 exchange is recognized as a loophole closer.
1031 Exchange
When real and personal property held in the productive use of a trade, business or investment are sold, federal and state capital gain taxes are imposed on the realized gain. Realized gain is determined by the original purchase price, plus improvements, less depreciation equaling adjusted basis. The selling price less the adjusted basis less the selling expenses equals the realized gain. In a 1031 exchange, given the property sold is not a primary residence, inventory, securities or bonds, indebtedness or partnership interests and replacement property is equal to or greater to the sales price along with a number of other rules, the capital gain is deferred. The recognized gain or tax is due when the taxpayer cashes out and does not initiate another 1031 exchange.
The justification for the gain deferral is that the taxpayer’s economic position is the same as it was when the original property was acquired. No benefit of either cash or reduced indebtedness was received, other than an interest free loan to use the otherwise payable tax dollars as additional working capital towards the replacement property purchase. The 1031 exchange allows:
- Businesses and individuals to replace poor performing assets with property better positioned to achieve their financial goals such as timber and Real Estate Investment Trusts (REITs)
- Aging infrastructure that has been heavily depreciated can be replaced with higher efficiency equipment
- Farmers are enabled to sell woodland for productive farm land
- Relocating taxpayers can sell their vacation rental and replace with a rental property closer to their new location
Budget Proposal
Instead of repealing the Treasury Regulation and Internal Revenue Service Code Section, the proposal “would limit the amount of the capital gain deferred under section 1031 from the exchange of real property to $1,000,000 (indexed for inflation) per taxpayer per taxable year.” This maintains the 1031 exchange for small businesses, trusts and individuals while also preserving personal property exchanges of aircraft, equipment and intangible personal property such as franchise rights. Corporations utilize 1031 exchanges to sell and replace shopping centers, apartments and hotels. The majority of 1031 exchanges are for properties sold for under $500,000; however, corporations defer more gain than the individual.
In addition, “Treasury would be granted regulatory authority necessary to implement the provision, including rules for aggregating multiple properties exchanged by related parties.”
Potential Impact
Those businesses or individuals with gains greater than $1,000,000 would lose their ability to defer the gain in a 1031 exchange and research alternatives such as the Deferred Sale Trust or monitor their potential gains to potentially sell based upon a pre-determined timeframe and price not to exceed the gain ceiling. REITs and corporations appear to be the potential losers given a portfolio of older properties. The affected taxpayers would tend not to sell their properties but hold them for a much longer timeframe. Potential ancillary losers may include the commercial property brokers and realtors, closing attorneys and title companies, lenders to contractors and tradesman given the improvements made when a new property is acquired. Though the impact to contractors and tradesman may be minimalized given older buildings require maintenance and improvements to maintain and elicit new tenants.
Whether or not the budget will gain the necessary traction is to be determined. For those taxpayers, considering a 1031 exchange and are seeking a Certified Exchange Specialist® to accommodate their exchange or respond to questions, click on the button below to inquire or initiate your 1031 exchange.
