Potential changes to the tax code currently being considered by the new administration, could change one huge area of real estate: the 1031 Exchange.
What is a 1031 exchange? It is a provision in the IRS tax code that allows a tax-exempt transaction for the sale and purchase of certain valuable properties1. If you already own a valuable item, like a home that you rent out, the exchange allows you to buy another “like kind” item without being taxed. It’s a popular way for people who own investment property to upgrade their property while avoiding a capital gains tax.
Property owners may also use the 1031 exchange to sell a property in one state and buy a similar property in a different state. It can be used as a tool for land owners to consolidate parcels from disparate locations2.
Interestingly, the 1031 exchange option is not just for real estate. It can also be used for other valuable holdings such as expensive artwork.
To buy real estate through the 1031 exchange option you must have a short list of properties identified as possible replacements within 45 days of selling your currently owned property. In addition, you have only a 180 day window to purchase the replacement property or properties and avoid tax.
You can use all or part of the proceeds from the sale of your current property to buy the replacement property, but anything you don’t use is subject to being taxed. In addition, you can’t put any of the money in your own bank account (or your own hands) so you need to work this process through a special intermediary.
One of the primary few advantages to a 1031 exchange is you can hold a property specifically for the expected increase in value, and then use that increase as the down payment for a replacement property or properties.
Without the 1031 exchange, the portion of taxes that would otherwise be deferred become due for the year in which the property is sold, reducing the available capital to acquire replacement properties.
However, not everyone needs the tax advantages of a 1031 Exchange. If you own a property but live in it for at least two years before you rent it, and then sell it within five years, the capital gains from the sale are tax exempt up to a set limit. Otherwise, taxes due on the capital gains may be deferred through the 1031 exchange
While the 1031 exchange has tremendous value to the real estate investor, it can be a source of criticism.
If the administration succeeds in getting rid of this option, tax experts estimate the government will gain an additional $40 billion in tax revenues over 10 years2. At the same time, real estate experts believe the loss will temper real estate market prices.
While those may be advantageous for the government and the general homeowner, there likely will be hits to the economy as well. Most experts expect the loss to increase the cost of consumer goods because the Exchange is used for business creation and expansion3.
If the 1031 Exchange option does get axed, how can you protect your assets? First, bear in mind that most federal programs have an end date in the future, so you should have time to make decisions.
However, in many markets like Colorado, real estate prices continue to increase while interest rates remain stable. In this type of market, one option is to sell your property and buy two through the 1031 Exchange. This provides additional rental units for the increasing number of individuals who can’t purchase a property.
Another approach may be to sell your current property and buy lower-priced property for cash and taking the hit for any gains. While the potential for future equity gains would be reduced, the lack of a mortgage payment, or a reduced one, increases the cash flow helping to recoup any losses.
When you’re looking to make your next move, working with a qualified real estate professional and financial advisors can help you make smarter choices.
Please comment on this article and let me know what your experiences are in the rental market.
References
Frequently Asked Questions, 1031 Exchange, www.1031exchange.com, April 24, 2017.
Terra Firma Current Threats Section 1031 100 Year Tax Tool, 1031 Tax Reform, www.1031taxreform.com, April 24, 2017.
Republican Tax Reform PLan Puts 1031 Exchanges on the Chopping Block, BisNow, www.bisnow.com, April 24, 2017.
Like Kind Exchanges Could Be At Risk Under Trump, CNBC, www.cnbc.com, April 24, 2017.
Image courtesy of Wikimedia Commons
