(Newswire.net— October 19, 2020) — October 19, 2020) — Most real estate investors would know about tax-deferred Section 1031 like-kind exchanges. For those who don’t, Investopedia helpfully defines it as an exchange of investment property that allows the entities involved to defer capital gains tax. The entities involved may be investors or companies that they have registered for holding real estate. Before 2017, individual exchanges of personal property fell under the 1031 exchange rules. However, in December of 2017, the Trump Administration signed the Tax Cuts and Jobs Act (TCJA) into law, removing the provision for personal property exchanges under the 1031 exchange rule. Now, we may be seeing even more cutbacks to the 1031 exchange when the next election rolls around.
Understanding the Basis of 1031 Like-Kind Exchanges
A 1031 like-kind exchange allows you to exchange one type of asset for a similar type of asset. It allows a business person to avoid paying capital gains taxes on their business assets and is primarily used to defer tax payments. Technically speaking, an asset owner can keep swapping assets, moving old ones and replacing them with new ones without having to pay the government any taxes on the increased asset value. You only pay the tax when you sell the asset for cash. If you keep swapping assets, however, you can defer the tax on capital gains indefinitely.
We’ve Heard This Before, Right?
In 2016, at the start of the Trump administration’s term in office, rumors were circulating about whether he’d remove Section 1031’s like-kind exchanges. However, the administration opted against it because of the severe operating impact it would have on a large volume of businesses. Construction, rental-car, and even airlines save money by using like-kind exchanges to improve their current assets and not having to pay excess tax on the new acquisitions. These savings are transferred to the customer.
Why Politicians See This as a Problem
Joe Biden’s Democrats see the 1031 like-kind exchange as businesses cheating the government out of taxes. With the Democrats planning a 10-year plan to fund over $2 trillion in relief and grants for the elderly and children, the money that businesses save through like-kind exchanges seem like a good place to start cutting back. Unfortunately, when it comes to the national economy, nothing like this is ever so easy.
There are like-kind exchanges that abuse the system, of course. There’s a like-kind exchange known as a swap-and-drop. A partnership with multiple members can trade a single property for properties equal to the relinquished property for the same value. Thus one ten-million-dollar property could potentially be exchanged for multiple ten-million-dollar properties depending on the amount of members in the partnership. This exchange makes it easier to dissolve the partnership as each member gets a value based on their share. However, this loophole could potentially move multiple properties using a single one as the “like-kind” trading fodder.
What politicians are missing about the like-kind exchange is that it presents a massive benefit to the economy. Removing the exchange sounds like a good idea until a government realizes how much it can impact the consumer if it is removed. The tax reforms that the Republicans passed in 2017 managed to get signed without the removal of the 1031 like-kind exchange because of how necessary it is to the running of the economy. Where, there, could the democrats institute their cuts?
When the Republicans signed their bill in 2017, it offered a lot of extraneous tax cuts to industries that didn’t need them. If Biden gets elected and the Democrats decide to pursue their relief programs, the most logical place to start would be by rolling back these tax cuts.
Two Pertinent Bits of Information
Two particular current events may affect the 1031 exchange overall. The Real Deal mentions that Joe Biden intends to obliterate 1031 transfers if he’s voted into office, in an attempt to control wanton moneymaking schemes. In addition to Biden’s statement, the IRS has also taken a hard look at the 1031 exchange and has released new guidelines for what can and cannot be considered real property eligible for like-kind exchanges under Section 1031. The more pressing of these to investors at the moment is the IRS regulations.
The TCJA’s Impact on Section 1031
When the TCJa came into effect, it squashed the use of Section 1031 to facilitate personal property exchanges. However, even though it stopped individuals from exchanging personal property, the trade’s like-kind aspect remained. Thus, the stipulation was changed, and while business owners could no longer exchange private property, they could do so with any property held for business or investment purposes.
The IRS Rules
The IRS has sought to clarify what is meant by “like-kind” property to ensure a definite property type that can be exchanged under Section 1031. Under the original stipulations of Section 1031, “like-kind” property eligible for exchange meant land, improvements upon the land, natural products that the parcel produces, and air and water that are over the plot of land in question. The IRS proposes that thus property be further defined as real property, which covers many more things. Any property, not just land, can be used for like-kind exchanges because the stipulations of “property” would be met.
What This Change Means for Investors
Real property can be any number of things. Works of art, machinery, and equipment can all be termed as real property. Under the new IRS rules, these real property items can be exchanged in a like-kind agreement under Section 1031. It also reopens the door for personal property transfer, if the private property is attached to related real property (the subject of the 1031 trade) and doesn’t surpass 115% of the real property’s value. The IRS changes may make it even better for business people who want to save the added value generated by their appreciated assets. These reliefs rely on whether Joe Biden is elected and decides to follow through on his proposals. If he does, then section 1031 and all like-kind exchanges would be no more.