Recently, the Obama Administration’s 2017 fiscal year budget proposed a $1 million limit per taxpayer on the annual deferral of capital gain. In addition, the budget renders art and collectibles ineligible for gain deferral.
The U.S. Department of Treasury notes that Section 1031 deferral had historically been justified on the basis that valuing exchanged property is difficult, which is no longer a valid argument. Most exchanges are complex three-party exchanges, facilitated by a qualified intermediary.
These types of exchanges were not contemplated when the provision was enacted. In addition, the U.S. Department of Treasury believes that the ability to exchange unimproved real estate for improved real estate encourages “permanent deferral” by allowing taxpayers to continue the cycle of tax-deferred exchanges.
This is not the first time that changes to Section 1031 have been proposed. Tax-deferred exchanges have been part of tax reform proposals in both the Senate and House of Representatives for several years.
Proponents of Section 1031 note that a repeal of tax-deferred exchanges will cause a decline in real estate values, as it discourages investors from selling and reinvesting in other property. Instead, investors will invest in more liquid, non-real estate investments with faster returns. Further, proponents argue that owners who have acquired property through like-kind exchanges do not have cash to pay the tax. As a result, it would be unfair for property owners to pay tax on the gain when they did not receive cash during the transfer.
With the upcoming change in administration, no one knows what the future holds for Section 1031. For the time being, tax-deferred exchanges are an excellent tool for real estate investors. They allow owners to defer payment of capital gains tax when selling property and reinvest the proceeds in like-kind property. However, the rules can be complex. Managing them correctly is vital to taking advantage of this longtime tax code benefit. If you are considering entering into a tax-deferred exchange, make sure to consult your tax adviser