A 1031 Exchange is a tax-advantage option in which a taxpayer can exchange one investment real property for another. Taxpayers are able to defer the tax consequence of the sale of the original investment property. The name comes from the Internal Revenue Code section authorizing the deferral of taxes which happens to be section 1031.
The Internal Revenue Code reads: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like kind, which is to be held either for productive use in a trade or business or for investment.”
This means that a real estate investor can change the form of their investment property without recognizing a capital gain for IRS purposes. It allows the investment to continue to grow tax deferred. The rules allow unlimited reinvestment, so properties can be rolled over multiple times without realization of taxes until the investor ultimately sells the properties for cash.
The ability to implement a 1031 Exchange has the potential to provide real estate investors with greater leverage, increased diversification, improved cash flow, geographic mobility and more. Qualified intermediaries are generally used to orchestrate the exchange since the investor cannot receive the funds from the sale of the original investment property. It is important to note that this is not a loophole. Taxes are simply deferred, not waived.
In recent years, members of Congress have threatened to introduce laws that would remove 1031 Exchanges altogether. This would have significant negative impacts on the real estate market. Part of The American Families Plan, which was introduced by the Biden Administration, is proposing to put a $500,000.00 limit on 1031 Exchanges. This cap would reduce liquidity in the market due to investors holding on to properties longer. This could drive down real-estate investments which would potentially make rents rise in the long term. Obviously, that is not a good situation for all parties involved.
However, this is merely a single piece of a much larger legislation package. Adding the limit to the 1031 exchange is one way the Biden Administration hopes to pay for other items in this bill. It is unclear if it will pass through the House and Senate. If it does, it probably will not be in its current form. The future of 1031 Exchanges are being decided today while our federal representatives work out this major bill.