What if President Biden Repeals Section 1031?
As we write in early 2021, among the particulars mentioned by Democrat lawmakers as a means of raising taxes is the repeal of or new limits on the like-kind exchange provision.
There has been some “deterioration” of IRC Section 1031 in recent times. We refer to the 2017 Tax Cuts and Jobs Act (TCJA) elimination of like-kind exchange treatment for exchanges of personal property.
The basic rationale of IRC Section 1031 in its current form is the absence of recognized gain, except to the extent of boot, because the owner remains invested in like-kind investment real estate.
The latest PLR on our topic, dated December 31, 2020, ruled favorably on a series of like-kind exchanges involving related parties. The IRS was persuaded that the principal purpose was not tax avoidance. Replacement properties had to be held for at least two years under Section 1031(f)(1)(C)’) (PLR 2020053007, December 31, 2020). We’ve yet to see private letter rulings on Section 1031 after President Biden took office on January 20, 2021.
What Has Biden Talked of Doing to Like-Kind Exchanges?
The official pronouncements from the Biden administration on Section 1031 exchanges seem missing. Commentary suggests Section 1031 was not written up, but only talked about by Biden spokespersons.
Will the specific avenues to higher taxes include repeal or severe modification of Section 1031? The circumstances suggest some likely cut-back in Section 1031 benefits, unless the impact on the real estate industry is judged so adverse as to warrant a hands-off approach, at least in the difficult economic circumstances of early 2021.
The adverse effect of the proposed changes to Section 1031, or its repeal, on the struggling real estate industry seem obvious (See 1031taxreform.com and related links, including Tax Reform Proposals,” Federation of Exchange Accommodators, 2021). At the same time, there are ongoing pandemic issues and an economy that struggles in many particulars.
Some mitigation of the prospects for enhanced gains tax on realty may be found in the impact of the COVID-19 pandemic on realty values generally, particularly reduced commercial property values in some markets. There’s also a context of massive governmental expenditures, which suggests government need.
Specifically, President Biden’s proposals talk of not allowing like-kind exchange treatment when the taxpayer’s ordinary income for the year exceeds $400,000. Some commentators suggest Biden will eliminate Section 1031 tax-free treatment altogether, whether the taxpayer is an entity or individual.
Other Biden administration proposals include elimination or mitigation of asset step-up at death (assuming appreciation) and significant increases in capital gains taxes, at least in many circumstances. The reports of purported increases in gains tax suggest rates as high as 39.6 percent. Reports suggest also the possibility of long-term capital gains being taxed at rates as high as 39.6 percent when taxable income exceeds $1 million.
The Nettlesome Details
If Section 1031 is basically eliminated or radically changed, will there also be more liberal deduction allowance rules when property with an unrealized loss is exchanged for similar property? Will the realty gain itself affect measurement of the $400,000, assuming such threshold for higher taxes?
One of the bothersome details is that the $400,000 threshold may not be known until year-end and how this affects estimated tax payments. Other questions arise:
- Will there be a range of phase-out as ordinary income exceeds $400,000?
- How will related-party rules impact the results?
- How will flow-through entity income affect the results, particularly when the flow-through entity results aren’t even known until K-1 issuance after year-end?
- Will income of C corporations affect the result?
- Can one control the earnings of a closely-held C corporation in a manner that avoids or mitigates higher taxes on the individual?
We note the Biden proposals generally include increasing the C corporate tax rate to 28 percent from the current 21 percent tax rate. Historically, there is a strong prejudice in favor of keeping realty outside of the corporate solution in closely-held businesses because of the double-taxation problem with C corporations.
There is also the gain-triggering problem with having realty inside of S corporations. Will there be an incentive now to having some realty appreciation gain inside a C corporation?
What if Biden Changes Section 1031?
First off, we will likely see more emphasis on installment reporting. If taxpayers in general, or only high-income taxpayers, don’t have access to Section 1031 then we will likely see more gifts of realty within the family. That gain might be spread out among multiple taxpayers, some of whom may also be younger and in lower tax brackets.
We may also see more charitable gifts of realty, including gifts of remainder interests in residences and charitable remainder trusts (CRTs). These CRTs permit retained (or gifted) income interests along with a partial charitable deduction for the actuarial value of the remainder interest (See Section 664).
Assuming step-up at death under Section 1014 isn’t repealed or is likely available to a particular estate considering its size, there will be an added incentive to retain property until death rather than engage in like-kind exchanges.
Enhanced capital gains taxation may bode well for qualified opportunity funds (QOFs). These focus on encouraging investments in economically disadvantaged areas. Realized capital gains reinvested within (generally) 180 days in QOFs in 2021 should qualify for 10 percent gain forgiveness after five years, deferral of gain until December 31, 2026, plus an absence of gains taxation on the investment itself if held for 10 years.
What of Section 1031 if There Is No Change?
We will likely see enhanced planning to take advantage of the existing provision. Writing in the first full month of the Biden presidency, we would generally anticipate that Section 1031 activity may well pick-up in the near-term, given the level of discussion of repeal. For example, in general, Section 1031 needs to take place at the entity level in a partnership context.
However, there is some planning room for avoiding partnership classification in favor of direct, partial ownership. This can result in some realty owners qualifying for like-kind exchange treatment on disposition of their interests even when the other owners retain their interests (See Regs. 1.761-2(a); Rev. Rul. 75-374, 1975-2 C.B. 261, Rev. Proc. 2002-22, 2002-1 CB 733; PLRs 200327003, 200513010, 200625009, 200625010, 200826005, 200829012, 200829013, 201622008).
In general, it is necessary to qualify as an “investment” rather than a business, which may be possible with a rental house, an apartment building, whereas a hotel/motel would normally be a business.
There is the prospect of Section 1031 going away or its scope being reduced. Tax-free treatment for exchanges of investment (non-dealer) realty may well be significantly diminished in the foreseeable future as one element of a tax-increasing legislation.
Mike Pusey, CPA is National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in audit and...