By Frank Dillow

A 1031 property tax exchange refers to a sale and purchase of “like-kind“ investment real estate completed under Section 1031 of the federal tax code. When one investment property is sold, it allows the tax on the gain from that sale to be deferred into another purchased investment property.

The provisions available under Section 1031 are purely for investment real estate. If the property is used as a home---even a second or third home, it does not qualify, unless it is leased and treated as an investment. Similarly, profits from “flippers” who buy a property in order to flip it for a profit do not qualify, as their profits are considered income under the tax code, not capital gains.

Because it is part of the tax code, the sale and purchase must comply exactly with the statutory language, or the tax benefit is lost and the seller will pay all taxes due from the sale.

Here’s how a Section 1031 exchange works. When sellers close on the sale of their real estate they have 45 days to identify up to three properties whose value totals at least as much as the sale price of the original property. The proceeds of the sale are given at closing to a disinterested third party, known as a “qualified intermediary,” who can be an individual, a bank or some other entity as long as they are not connected to the seller. The intermediary holds the money until it is released in order to complete the purchase of replacement real estate. The “like-kind” replacement property does not need to be identical to the sold property -- it can actually be up to three properties – but all must be investment real estate located in the United States. The provision does not apply to purchases of foreign properties. The purchase(s) must be completed within 180 days of the original sale, at which time the intermediary facilitates the transaction by transferring the title of the replacement properties to the new owner.

In this way the seller never receives the cash from the property sale, but winds up with a new property or properties of at least equal value, just as if the properties had been “swapped.”  If the price of the new properties is less than the sales price of the original property, the cash difference is given to the seller and that portion is outside the limits of the 1031 exchange and is subject to taxes.

The deferred tax from the sold property comes due when its replacement is sold. However, the taxpayer can again exercise the provisions of Section 1031 on the sale of this property and defer the taxes further by again “swapping” for up to three additional properties. This can be done as long as the seller lives, creating a “swap ‘till you drop” tax strategy. When the property owner dies, the property becomes a part of their estate and is subject to any estate taxes that may apply.

“First adopted one hundred years ago in 1921, Section 1031 was originally designed to allow farmers and other taxpayers to ‘swap’ property of equal value without paying taxes, at a time when cash was scarce and the need to pay taxes on the sale would have seriously discouraged the transaction,” explains Bill Horan, whose family has facilitated 1031 exchanges as “certified exchange specialists” for the past 90 years.

“Backward swaps” were included in the deferral with Congressional revisions to the code in 2000. Since then, an investor has been able to first purchase up to three new properties through an intermediary, and then sell the old property and still defer taxes on the sale of the old property into the already purchased property, even though the sale of the first property occurs after the purchase of the replacement property.

As first enacted, the “like-kind exchange” included both real estate and other kinds of property, such as vehicle fleets or heavy equipment. Largely because of the perception that Section 1031 created a tax loophole allowing wealthy taxpayers to avoid taxes on the sale of their personal art collections or yachts, the tax reform act of 2017 eliminated tax deferrals for like-kind exchanges for all assets other than real estate.

Now the remaining real property provisions are again under attack.

In President Joe Biden’s budget proposal currently before Congress, the Administration proposes to limit the deferred benefit to $500,000 for each transaction, beginning December 31, 2021. A decision will likely be made by Congress to either adopt the restriction, or even eliminate the entire deferral, when they adopt their “budget reconciliation” legislation later this fall. Virginia Senator Mark Warner and Rep. Don Beyer are both members of their Congressional tax writing committees and will be key players in the outcome.

A coalition of 23 different organizations including the National Association of Realtors®, along with organizations for developers, investors, lenders and even farmers and foresters, have come together in an attempt to preserve the current deferral. They argue that such action could encourage taxpayers to sit on their assets and not purchase investment properties. As a result, existing properties could deteriorate as investors have less incentive to renovate or repurpose their properties for resale.

Horan’s firm, the Realty Exchange Corporation, has facilitated the sale of literally millions of properties during the past 90 years, mostly of the single transaction “mom and pop” variety. “They are the ones who will be hurt by these proposed changes,” Horan predicted.

Today, studies performed for the coalition show that 10-20% of all sales of investment property, including 40% of multi-family exchanges rely on Section 1031.

“As property owners strive to put diversity and inclusion concepts into action, the like-kind exchange established in Section 1031 of the U.S. tax code can serve as a powerful tool that fosters economic development and promotes job growth for people from all walks of life,” the NAR explains in a May 6 white paper.

NAR advises that Realtors® can play a key role educating their Congressional delegations on the importance of this provision. “Who better knows the communities and economies of the states and districts of Senate and House members,” the NAR pointed out. “Who can better pull together key commercial leaders to meet with policymakers and convince them that success in rebuilding and hiring has, and can again, come from carefully planned real estate development, based in many cases on the bedrock of like-kind exchanges?”

To learn more and to share member stories about like-kind exchanges that will help to educate lawmakers and their staff, click here.

Frank Dillow is an NVAR instructor and a senior commercial broker in Long & Foster’s Commercial Division. He can be reached at francis.dillow@longandfoster.com.