Last week was a little more "big picture" so today we are digging into a very specific real estate topic: 1031 exchanges and their possible elimination.
A 1031 exchange allows an owner of an investment property to avoid capital gains taxes by taking the proceeds of a sale and putting it towards another purchase.
This has helped some small investors, but massive organizations have used a string of exchanges to defer tens (or hundreds) of millions of dollars in taxes that cities need for their budgets, especially now. And there is a renewed push to adjust or eliminate the option.
xo
Anna
What’s The Deal?
1031 or "like kind" exchanges allow an owner to avoid paying capital gains taxes (20%) on the increased value of their home. For example, if you bought a condo for $100k and now it is worth $200k, you would owe $20k in capital gains taxes, but you could get out of it by putting the proceeds towards a new purchase.
This has a few main conditions:
1. It must be an investment (rental) property or a "productive" property (ie. farmland), and you must have a history of declaring/paying taxes on the income from this investment.
2. You must identify three properties of interest within 45 days of selling your original property, and close on (buy) one of those three properties within 180 days.
3. Both the purchase price and the loan on the new property must be larger than the original (ie. a $1m property with an $800k loan for a $1.1m property with a $900k loan).
Again, note that 1031 exchanges are only allowed on investment properties. Avoiding capital gains on your primary residence is simpler but more limited; I'll write something about that in the future!
Like kind exchanges have been around for decades, but have recently found the spotlight. In 2017, the new tax law eliminated this kind of tax-deferral exchange EXCEPT for in real estate transactions. Before that, companies were able to do "like kind" exchanges on everything from rental cars to farm equipment.
The 1031 exchange is a HUGE financial boon to real estate investors, and it isn't the only one. From Bloomberg: "The exemption is projected to save property investors $51 billion between 2019 and 2023, according to Congress’s Joint Committee on Taxation. It’s not the only benefit in the tax code that primarily favors property investors. Real estate developers can claim write-offs for losses on borrowed money. They also get to claim depreciation on buildings, which, unlike farm equipment or factory machinery, generally increase in value."
While I know some small investors who would benefit from the 1031 exchange option, many of the NYC beneficiaries are billionaires with massive portfolios. These types of exchanges aren't necessarily easy or straightforward, so the savvier investors tend to be the ones utilizing them. Said investors already take advantage of every loophole mentioned above to lessen their tax burden, as is their right. But with all their other options I'd argue they don't need this one.
Why Does This Matter?
1031 exchanges have made headlines recently for two reasons:
First, in June the Trump Organization discussed selling two properties in NYC and SF for roughly $2billion. These buildings were purchased in a like kind exchange with proceeds from an earlier UWS sale. His position in government could make using these proceeds for yet another 1031 exchange difficult, and if the exchange doesn't happen the organization would owe tens of millions in taxes.
Second, Biden recently proposed eliminating the 1031 for real estate the way Trump's administration eliminated it for all other businesses. Of course certain people in real estate (like reason I just quit Equinox Stephen Ross) are yelling about how this is unfair, but again, it was Trump's administration that dismantled the program. Biden would simply be finishing the job.
We as a country will need to make some tough decisions over the next few years to undue the damage the GOP and coronavirus have done to our finances. No one is excited about paying higher taxes and most of us are already hurting financially, so closing loopholes and funding the IRS so it can actually go after companies/individuals avoiding their fair share may be our best bets.
Further Reading/Watching
To read more about 1031 exchanges and other ways real estate moguls avoid taxes please check out the links below.
Bloomberg - What Is the Like-Kind Exchange Rule That Biden Wants Dead (article)
Pro Publica - Here’s How Trump Transferred Wealth to His Son While Avoiding the Usual Taxes (article)
NY Times - How Loopholes Help Trump and Other Real Estate Moguls Avoid Taxes (article)