For the past year, the real estate investment community has feared that, among other things, the 1031 Tax Deferred Exchange could be on the chopping block under a Democratic administration.
First, a quick primer on 1031 Exchanges. The tax-deferred exchange, as defined in Section 1031 of the Internal Revenue Code, allows a property owner to sell their investment property and defer the taxes that would normally be due upon that sale.
To fully qualify, an owner must: (a) acquire “like kind” Replacement Property that will be held for investment or used productively in a trade or business, (b) purchase Replacement Property of equal or greater value, (c) reinvest all of the equity into the Replacement Property, and (d) obtain the same or greater debt on the Replacement Property.
Debt may be replaced with additional cash, but cash equity cannot be replaced with additional debt. Additionally, the exchanger may not receive cash or other benefits from the sale proceeds during the exchange.
When the Biden administration took office, there was a lot of talk about doing away with the 1031 Exchange system in an effort to raise additional taxes. This would affect a large number of small mom-and-pop investors who bought investment properties as a way to build wealth for their families.
If the exchange option were eliminated then any appreciation in the value of the investment property would have been taxed upon a sale. There would be no way of further deferring those taxes through reinvestment. This would cause the number of sales each year to plummet and the value of properties to drop as demand for investment properties would have dried up overnight.
Throughout the summer and into the fall, negotiations were being held that would decide the final form of the multi-trillion dollar economic plan. Politicians spent weeks moving things on and off the table, and only over the past week or so did the final framework come together.
Members of the House Ways and Means Committee sent out letters recently to their constituents letting them know that Section 1031 of the Tax Code was safe. While the bill has yet to be finalized and voted on, we can be assured that the Tax Deferred Exchange is safe, for now at least.
Brian Johnson is the new president of the Santa Barbara Association of Realtors. He is a California licensed real estate agent and the managing director of Radius Commercial Real Estate. Brian handles all types of commercial real estate transactions, but has a special focus on multifamily investments. He can be reached at 805.879.9631 or email@example.com.