For almost a century, investors have been able to take advantage of Section 1031 in the IRS code as a tax-deferral strategy on “like-kind” property exchanges. But this method, commonly known as the 1031 exchange, could be in danger if a tax reform plan passes.
What are 1031 Exchanges?
A 1031 Exchange, also called a Like-Kind Exchange or a Starker Exchange, allows the gains you make on a property to be tax-deferred (tax-free) and gives you the opportunity to put them towards a new property. With a 1031, the property you’re selling must be in exchange for a “like-kind” property, not anything else. This method is not a tax elimination, but it gives you the option to defer into another income producing property.
For example, say someone bought a million-dollar property. They hold it for 10 years and after those 10 years the property’s value increases to two million. Their taxable gain is now a million dollars. Out of a million dollars – depending on the tax rate – they might be looking at paying in excess of $250,000 in taxes. Using a 1031 Exchange, they could defer paying that large amount in taxes by exchanging it for another investment property, but only if they re-invest the whole two million dollars into the new property. Any of the money they don’t re-invest is considered boot, and those dollars would be subject to capital gain tax.
How could tax reform affect landowners and sellers?
Recently, there’s been considerable talk about the possibility of eliminating 1031 exchanges. If a government plan for tax reform is passed, there could be consequences for the land industry. For landowners, it would take away some of their estate planning. From a real estate standpoint, it could almost be catastrophic to land sales. If people don’t have something they can move their money into – whether it’s recreational or commercial – if they don’t have that ability, why would they sell? Doing away with 1031s would slow the market down considerably.
“The 1031 gives sellers options and creates economic development. It’s not just about farmland, it’s commercial, recreational, etc.… Without the 1031 option, they’ll have to pay capital gains. They’ll have less incentives to go out and purchase new properties that will stimulate economic development. A lot of people won’t sell if they don’t have that option,” said Jeramy Stephens, ALC and NLR Broker/Partner.
As of right now, the 1031 exchange is not on the chopping block. There are no proposals from the tax committee saying it has been eliminated. However, it remains a hot topic among government officials who consider 1031s as a loophole.
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