Financial and investment advisers should seek to understand the implications of a legislative proposal originally set forth in the American Families Plan that would severely limit benefits historically provided by Sec. 1031 of the Internal Revenue Code. Under the proposal, the deferral of capital gains from the exchange of real property used in a trade or business, or of investment property, would be limited to $500,000 ($1 million for married individuals filing jointly). At the time of this writing, Congress is actively considering major tax legislation that may include such a limitation on Sec. 1031 exchanges.
The discussion below summarizes the changes proposed that would affect deferral of capital gains and depreciation recapture related to exchanges of like-kind real property. As will be seen, investors would experience a significant loss of tax benefit from carrying out such an exchange if the White House proposal is enacted.
TIME TO CASH OUT
With housing prices at all-time highs, interest rates at all-time lows, and an ever-shrinking inventory of available homes, real estate owners may be considering whether to cash out or leverage equity, given the current economic climate as this is being written. According to the National Association of Realtors, median home prices in September 2021 were up 13.3% compared with the same time a year earlier (NAR, Summary of September 2021 Existing Home Sales Statistics). Meanwhile, interest rates on 30-year fixed-rate mortgages have remained flat at an attractive rate of just above 3% on average. Investors who have experienced appreciation in the current strong real estate market might consider selling their property while housing prices are at market highs, which for many would mean recognizing capital gains. Alternatively, property owners might want to capitalize on increased appreciation by reinvesting in other income-producing properties. Tax professionals and trusted advisers should be prepared to educate their clients regarding the potential tax consequences of sale or reinvestment decisions.
Sec. 1031 provides for deferral of capital gains on the exchange of property held for productive use in a trade or business, or for investment, for replacement property that is also held for productive use in a trade or business or for investment purposes (Regs. Sec. 1.1031(k)-1(a)). In other words, an investor can exchange one investment property for another investment property without triggering a taxable event, assuming the rules of Sec. 1031 are properly applied.
Sec. 1031 also provides for the deferral of depreciation recapture, currently taxed at a flat rate of 25% upon sale of an investment property. If an asset has been held and depreciated over a long period of time, depreciation recapture can be a huge consideration in the sale/reinvestment decision, since the tax owed on recaptured depreciation may be as much as or greater than the overall capital gains tax. Deferral of taxation in a reinvestment situation is in keeping with a long-held sentiment that taxes should be collected when taxpayers have the wherewithal to pay. If the proceeds from the sale of an investment property are being reinvested, the taxpayer may not have the wherewithal to pay income taxes.
President Joe Biden has proposed numerous changes to the tax code that would significantly affect investors who are making the sale/reinvestment decision. As of this writing, Congress is considering major tax reform, and one of the many proposed changes is a limitation on the amount of gain that may be deferred in a reinvestment situation. Specifically, Biden has proposed limiting capital gain deferral in a like-kind exchange to a maximum of $500,000 ($1 million for married individuals filing a joint return). The American Families Plan further proposes to tax long-term capital gains as ordinary income at a rate of 39.6% for higher-income earners, compared with the maximum long-term capital gains rate today of 23.8% for high-income earners (20% long-term capital gains rate plus 3.8% net investment income tax). Under the American Families Plan, when the 3.8% net investment income tax is added to the proposed maximum long-term capital gains rate, high-income earners would pay as much as 43.4% on long-term capital gains. Although the details of the proposed changes are still taking shape as of this writing, increased taxes are expected on both earned and capital income.
LIKE-KIND EXCHANGES: OWNERSHIP, DEADLINES, AND OUTCOMES
Planning, preparation, and execution of a like-kind exchange is a very rules-based endeavor. Taxpayers and their advisers must be aware of potential pitfalls that can derail any attempt to accomplish a tax-deferred swap of properties. For example, if taxpayers fail to identify replacement properties in a timely manner, or if the proceeds from the relinquished property are not properly handled by an independent third party, an intended like-kind exchange may be treated as a sale and subsequent purchase for tax purposes. The following issues must be addressed when structuring a Sec. 1031 exchange.
Issue No. 1: What is 'like kind'?
It is important to keep in mind that, for purposes of Sec. 1031, gain deferral is only applicable to property that is of "like kind." A taxpayer's primary residence does not qualify for this type of tax treatment. Gain of up to $250,000 for a single taxpayer ($500,000 for a married couple filing a joint return) from the sale of a primary residence is excluded under Sec. 121, rather than deferred under Sec. 1031. Additionally, for purposes of the like-kind test, Sec. 1031(h) states that real property used in the United States and real property used outside of the United States are not like-kind properties. Therefore, one could not exchange an investment property in the United States for an investment property in France or Ireland and accomplish the goal of gain deferral. Finally, if money or other nonqualified property is included in a like-kind exchange, the money or other property is not considered like kind and may trigger gain recognition (Regs. Sec. 1.1031(d)-1(e)). One other important point about the meaning of "like kind" is that partnership interests cannot be exchanged tax-free under like-kind exchange rules (Regs. Sec. 1.1031(a)-1(a)(1)), even if the underlying assets of the partnership include land. Consequently, a partnership interest owning land cannot be replacement property for land relinquished. Additionally, there must be a continuation of ownership such that both the replacement property and the relinquished property are held by the same taxpayer.
Issue No. 2: Time constraints
Two critical deadlines must be observed to prevent a taxable exchange of like-kind property. First, the taxpayer, or a qualified intermediary (QI), must identify replacement property or properties in writing within 45 days from the date of the transfer of the relinquished property. Second, the taxpayer must acquire replacement property pursuant to a Sec. 1031 exchange agreement within 180 days from the date of the original transfer of relinquished property or the due date (determined with regard to extension) for the taxpayer's federal income tax return for the year in which the transfer of the relinquished property occurs (Regs. Sec. 1.1031(k)-1(b)(2)).
It is important to note that if a taxpayer initiates a Sec. 1031 exchange near the end of the year and the exchange has not been completed by the due date of the taxpayer's return, presumably April 15, then the taxpayer must file for an extension of his or her personal return to preserve the 180-day exchange period. Otherwise, the taxpayer's 180-day period will end on the due date of the tax return, thereby triggering gain recognition on the incomplete Sec. 1031 exchange.
Issue No. 3: Receipt of proceeds
To ensure that none of the proceeds from the relinquished property are either actually or constructively received by the taxpayer, thereby triggering a taxable event, the taxpayer should enter into an exchange agreement with a QI. A QI is an objective third party who will sell the taxpayer's relinquished property, hold the proceeds, then purchase the taxpayer's acquired property and transfer the property to the taxpayer. The QI cannot be a disqualified person (i.e., (1) a person who is the agent of the taxpayer at the time of the transaction; (2) a person who bears with the taxpayer a relationship described in either Sec. 267(b) or Sec. 707(b) (substituting in each section "10 percent" for "50 percent" each place it appears); or (3) a person who bears a relationship described in either Sec. 267(b) or Sec. 707(b) (again substituting in each section "10 percent" for "50 percent" each place it appears) with an agent of the taxpayer).
This is critical information for the tax accountant or financial adviser because, if you have acted as the taxpayer's agent (for these purposes, a person who has acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker) within the two years prior to the Sec. 1031 exchange transaction, you are a disqualified person who cannot serve as the taxpayer's QI.
However, your relationship to the taxpayer and your accounting expertise may be essential in helping the taxpayer locate an appropriate QI and in consulting on the exchange. Skill, expertise, and integrity are crucial characteristics for the chosen intermediary. For an excellent resource on this topic, see Ray and Lynch, "Selecting a Qualified Intermediary for a Like-Kind Exchange," CPA Journal (October 2016), available at www.cpajournal.com.
Issue No. 4: Build in flexibility
Taxpayers who wish to utilize the rules of Sec. 1031 are not limited to a one-for-one property exchange. According to Regs. Sec. 1.1031(k)-1(c)(4), more than one replacement property may be identified. In fact, taxpayers may identify up to three replacement properties of any fair market value (FMV) by the end of the 45-day identification period, or any number of properties so long as their total FMV does not exceed 200% of the total FMV of the relinquished property or properties as of the date of their transfer.
For example, a taxpayer who wishes to relinquish an apartment building with an FMV of $2.2 million in a like-kind exchange may identify multiple replacement properties in the following manner: an office building with an FMV of $1.4 million, a warehouse with an FMV of $1.1 million, a second warehouse with an FMV of $1 million, and a rental house with an FMV of $700,000, equaling a total FMV of $4.2 million. Provided that the replacement properties are identified in writing within the 45-day identification period, the taxpayer is in compliance with the 200% rule because the identified replacement properties have a total FMV that is less than 200% of the FMV of the relinquished apartment building.
If, at the end of the 45-day identification period that applies in a deferred like-kind exchange, a taxpayer has identified more replacement properties than allowed under these rules, the taxpayer is treated as if no replacement property had been identified. However, certain exceptions apply to this rule (see Regs. Sec. 1.1031(k)-1(c)(4)(ii)).
Remember that time is of the essence in executing a successful tax-deferred swap. Identifying multiple replacement properties will add some flexibility in case one or more properties become unavailable before the end of the replacement period.
THE NATURE OF A LIKE-KIND EXCHANGE
It is unlikely that an investor who wishes to exchange investment or commercial use property would be able to execute a simultaneous transfer with a like-minded investor. Rather, the exchange would likely be accomplished in two sales transactions such that the relinquished property is first sold to an independent third party, with the proceeds held in escrow, until replacement property or properties can be identified and acquired. Generally, a like-kind exchange would more likely take place in stages: relinquishment of appreciated property or properties, identification of replacement property or properties, and acquisition of replacement property or properties and transfer of the property or properties to the taxpayer. Furthermore, these stages would likely occur over a period of weeks or months.
As a practical matter, the Sec. 1031 exchange is usually facilitated by executing an exchange agreement with a QI to ensure that the taxpayer never has access to the sales proceeds from the relinquished property. If the taxpayer receives any of the proceeds from the relinquished property in cash or other property that is not of like kind, this amount is considered "boot" and is immediately taxable (Sec. 1031(b)). Likewise, if the taxpayer is relieved of any debt resulting from the Sec. 1031 exchange, the reduction in debt is considered taxable boot as well. To avoid taxable boot, the newly acquired property must be of equal or greater value than the relinquished property, and any mortgage on the replacement property should be of equal or greater debt. For illustrative purposes, our discussion here is limited to exchanges involving appreciated property, since gain deferral is the focus of this article.
Taxpayer A owns an office building that she purchased in 2011 for $2,100,000 with a current mortgage of $1,000,000. A improved the building with a new roof several years ago and took annual depreciation deductions so that the current adjusted basis of the office building is $1,760,000, calculated as shown in the chart "Adjusted Basis of Office Building."
A, a high-income taxpayer, intends to sell the office building for $3,250,000 and replace it with an apartment complex. The realized gain on her relinquished property is shown in the chart "Realized Gain on Relinquished Property."
If A decides to structure the sale of her property as a like-kind exchange, she must fully reinvest the proceeds from the sale of the office building. To preserve her Sec. 1031 status, A cannot receive any of the proceeds from the original sale. Consequently, A must determine how much cash will be received upon relinquishment of her original property so that she knows how much must be reinvested. If A sells the office building for $3,250,000 and pays off her mortgage of $1,000,000, she will have $2,250,000 to reinvest.
A must purchase a replacement property for an amount that is equal to or greater than the sales price of the relinquished property, and she must obtain a mortgage on the new property that is equal to or greater than the mortgage on her original property. In this situation, the purchase price of a replacement property should be greater than $3,250,000, and a mortgage on the replacement property should be greater than $1,000,000.
A comparison of the tax consequences to A of selling her office building in exchange for an apartment building under three scenarios is presented next.
Scenario No. 1
A sells her office building outright. She will pay income taxes as shown in the chart "Total Tax Liability From Sale of Relinquished Property" (using 2020 tax rates and assuming she is a high-income earner).
Scenario No. 2
A sells her office building using a Sec. 1031 exchange (using current tax rules). Consequently, she defers all gain recognition and depreciation recapture, saving $378,870 of income tax in the current year, which can be used for reinvestment purposes.
Scenario No. 3
A sells her office building using a Sec. 1031 exchange (using proposed tax rules). Assuming that depreciation recapture rules are unchanged, she will pay income taxes as shown in the chart "Taxes From Like-Kind Exchange Under Proposed Changes."
The chart "Total Tax Liability From Sale of Relinquished Property Under Proposed Rules" shows the tax consequences under the proposed changes if A sells the property outright.
If the changes proposed under the American Families Plan are assumed in this example to have been enacted, we can observe that the tax benefits of exercising a like-kind exchange are drastically diminished. The taxpayer pays $198,000 less in tax using a Sec. 1031 exchange versus an outright sale, a significant reduction from the $378,870 in tax savings that would accrue from using a like-kind exchange under the current rules; however, the like-kind exchange is still the better option.
Use of a like-kind exchange is appropriate in myriad situations. For example, investors may relinquish a single-family home in exchange for an apartment building, a warehouse in exchange for an office building, or one investment property for multiple properties. Taxpayers may seek improved cash flow investments, decreased management responsibility, or simply a geographical relocation. Provided both the relinquished property and the replacement property are used in a trade or business, or used for investment purposes, and provided the replacement property is owned by the same taxpayer, Sec. 1031 gain deferral may be applied. If the Biden administration is successful in eliminating or significantly limiting gain deferral under Sec. 1031, taxpayers may incur substantially increased tax liabilities on future like-kind exchanges of real property.
UNCERTAIN OUTLOOK FOR LIKE-KIND EXCHANGES
Sec. 1031 is a decades-old tax provision that has incentivized growth in the real estate industry for many years. However, Sec. 1031 may not be a viable option for high-income taxpayers in the future, given the current political climate. While Sec. 1031 provisions remain in place, CPAs should be prepared to inform and educate their clients regarding how to take advantage of the deferral of capital gain and depreciation recapture in the current unprecedented times of market appreciation and low-interest-rate financing. Successful completion of a like-kind exchange is an extremely rules-based endeavor, which, in most cases, will require the assistance of both a CPA and an independent intermediary to achieve the desired outcome.
About the author
Dana L. Hart, CPA, Ph.D., is an assistant professor of accounting at the University of Southern Mississippi in Hattiesburg, Miss. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld, a JofA senior editor, at David.Strausfeld@aicpa-cima.com.
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"Like-Kind Exchanges of Real Property: New Final Regs.," The Tax Adviser, April 2021