Changes in the tax code are imminent, and the Biden Administration has made no secret about the fact that it intends to alter the rules for the 1031 Exchange program, possibly putting a cap on the values of transactions that can qualify. This is combined with changes to capital gains rates, the step-up basis, and other elements of tax law that will affect 1031 investors.
The question then becomes: what do we do about this? Is there a way to protect the program? What should those who planned to sell property in the coming years do to prevent paying higher rates? We’ve recruited experts from across the industry to address what is likely to happen and what ought to be done.
Louis Rogers, Founder and Chief Executive Officer of Capital Square, says “tax reform appears to be on the horizon,” and that “ordinary tax rates appear to be going up, in a very big way.” Tax reform will affect many people, not just 1031 investors, so those who care about the program need to be vocal in order to keep the issue from fading into the background.
“The real estate industry is lobbying Congress” to show the benefits of Section 1031, including “the jobs created, the taxes paid, the ability to take real estate to its highest and best use,” says Rogers. But that might not be enough. According to Justin Amos, 1031 specialist at JTC, individuals shouldn’t just rely on industry groups. “Please contact your senators and let them know you don’t want anything to change with 1031 exchanges,” he says. “Your voice matters now more than ever.”
Investors can get involved in various initiatives and reach out to their representatives, but the industry also needs to keep its eyes on data. The simple fact is that many members of Congress do not understand the program, and need to be educated about its benefits. Hard facts are what can demonstrate the program’s effectiveness, and a commitment to reporting based on data-driven technology, a point of pride for JTC, is what will provide undeniable proof that 1031 has been a success.
But what if the reforms pass anyway?
“If we are unsuccessful,” says Rogers, “it is likely that the changes to Section 1031 would be prospective, so it is likely that your exchange would be secure and you could own a satisfactory replacement property long term.”
Of course, that’s only if the exchange is completed. “If you own appreciated investment real estate you would like to sell and if you are able to sell for a satisfactory price, now is the time.”
Kenneth L. Zakin, Senior Managing Director of Newmark and a member of its Capital Markets Group, agrees that those who are looking to sell as part of a 1031 exchange should “accelerate sale of properties to 2021 to take advantage of 1031 exchanges while they still exist.”
Even if investors aren’t planning to sell a property in the near future, they should still have a plan in place, says Amos. “I always tell our clients ‘the earlier you plan for a 1031 exchange, the easier the transaction becomes.’”
As for finding that replacement property, a cap could make it more difficult, but there are other ways to take advantage of 1031, like the use of Delaware Statutory Trusts. “If these reforms do come to pass, we expect DSTs to become a more prominent form of investment,” says Amos. “It would help investors diversify a portfolio as well as ensure they don’t exceed the $500k cap once the offering goes full cycle.”
Zakin recommends taking a long view of any new property purchased as part of an exchange. “Buy real estate with intention to hold for long term,” he says. This is due to both changes to 1031 and capital gains rates, which may go up and stay that way for a long time.
“Consider real estate as an alternative asset class and evaluate based on cash flow, after tax cash yield, and inflation hedge while building long-term value that might be realized in the future, perhaps under a more real estate-friendly tax regime.”
Smart investors are acting now to protect themselves as best they can against alterations to 1031 and other parts of the tax code, because we don’t ultimately know what the final version of these changes will look like. There is still time to affect the decision-making process, and those in the industry who care about 1031 are doing everything they can to demonstrate its value so it can continue to create jobs and have a positive effect on communities while helping ordinary investors create wealth through property.