Capping 1031 Exchanges will Result in Economic Stagnation, Not Recovery

The 1031 exchange is an essential tool needed to rebuild the American economy after the damages done by the COVID-19 pandemic – and it is at serious risk as part of the American Families Plan being considered in Washington.

Every community in the nation, including those here in the Twin Cities, have witnessed the closing of countless malls, shopping centers, hotels, office buildings, and restaurants due to the fallout from the pandemic. In order to regain economic strength, we will need to substantially reinvest in and repurpose these properties. 1031 exchanges are a perfect tool for accomplishing just that!

1031 Exchange History

For the past 100 years, 1031 exchanges have been a cornerstone of the U.S. commercial real estate market. Like-kind exchanges generate economic benefits which far exceed the amount of taxes deferred. The American Families Plan proposes to cap the amount of gains that can be deferred via 1031 exchange at $500,000. This is a counterproductive cap that would result in economic stagnation, not recovery.

Contrary to a common misconception, a 1031 exchange is a deferral, not an elimination of tax. According to a study done by professors David C. Ling (Univ. of Fla.) and Milena Petrova (Syracuse Univ.), 80% of the taxpayers who conduct a 1031 exchange do only one exchange and then dispose of the property in a taxable sale. A restrictive cap on commercial real estate reinvestment would send an already struggling market into a tailspin.

1031 Exchanges Create Jobs

1031 exchanges are also a powerful job creation tool. Ernst & Young estimated that the reinvestment through 1031 exchanges for the coming year will create more than 560,000 new jobs paying more than $27.5 billion in labor income, generate $14 billion in federal, state and local taxes and add $55 billion to the GDP.

For many in the middle class, including many Black, Latino, and Asian realtors and investors, 1031 exchanges serve as their retirement strategy. Many of these groups are, for the first time, beginning to realize the hope of creating intergenerational wealth and a comfortable retirement by investing in real estate. They should not have to face the threat of a cap on using 1031 exchanges to attain these goals. 

What are Qualified vs. Non-Qualified 1031 Exchange Expenses

In a 1031 exchange, you have to be very careful in handling your expenses. What are qualified exchange expenses that you may use on your 1031 closing expense sheet, and what are non-qualified expenses?

A General Rule

The general rule is you’re supposed to move all of your equity from the sale of the relinquished property into the new replacement property. However, the exception to the rule is that you can pay certain qualifying expenses. The classic example is the real estate agent's commission on the relinquished property. You can also pay the title company, the county recorder, and other customary expenses that would be seen in that locality.

Non-Qualified Expenses

You probably can't put your Home Depot credit card bill or your Netflix charges on the settlement statement because you don't customarily see those expenses on closing statement and they're probably not related to the sale of the relinquished property.

Debt

Sometimes people want to pay off debt that may or may not be secured by the property. While that is not really an expense related to the sale, it is a cloud on title that oftentimes has to be removed in order to convey marketable title to the buyer. If the debt is secured by a mortgage or other lien it's clear that it has to be paid and is appropriate to be paid on the settlement statement.

Where it gets a little dicey are notes and other loans that may not necessarily be secured by the property, or encumber the property but for which there is a contractual requirement that the debt has to be paid if the property is ever sold. In those situations, the IRS will permit you to use exchange funds to pay off that debt that you are contractually required to pay, and you may be able to offset that debt relief with new debt on the replacement property so that the old debt does not trigger boot or mortgage boot on the sale of your old relinquished property.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

The Danger Behind Biden’s Plan to Restrict 1031 Exchanges

The resilience of the commercial real estate market has been put to the test during the past year and a half as the pandemic forced many retail centers, restaurants, hotels, and office buildings to close.  

Post-Pandemic Economic Recovery

Hope is on the horizon as more people get vaccinated and we begin to recover economically from the COVID-19 pandemic. Commercial real estate can (and should) play an essential role in that recovery. But President Biden’s plan to restrict 1031 exchanges to properties under $500,000 will have adverse effects that will cripple commercial redevelopment at a time when we need that investment more than ever.

The 1031 Exchange is Not a Loophole

One of the most pervasive and damaging myths surrounding 1031 exchanges is that they are a loophole of some kind that taxpayers use to avoid paying their fair share. This could not be further from the truth. Numerous studies have shown the opposite to be true. A microeconomic study on 1.6 million properties conducted by professors David C. Ling (Univ. of Fla.) and Milena Petrova (Syracuse Univ.) concluded that 80% of replacement properties acquired in a 1031 exchange were ultimately disposed of through a taxable sale, with all of the deferred taxes getting paid within roughly a 15-year window. A macroeconomic study initiated by Ernst & Young in 2017 and recently updated, concluded that if section 1031 was limited or repealed, it would shrink GDP by a whopping $9.3 billion per year. 

The Many Benefits of 1031 Exchanges

The economic benefits of 1031 exchanges far exceed the assumed cost to the Treasury from these temporary tax deferrals (with ‘deferral’ being the operative word – as these taxes are eventually paid). Ultimately, the Treasury receives its money, states and cities enjoy increased taxes generated by the healthy redevelopment of commercial property, and the economy is strengthened through job creation and retention.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

What to Know About 1033 Exchanges and Involuntary Conversions

Section 1033 (a close cousin to 1031) allows you to defer the gain when you lose your property due to an involuntary conversion such as theft, condemnation, conversion, eminent domain takings, etc. The benefits of a 1033 exchange are that you get to defer that gain. In some ways, 1033 is better than 1031 because you have a longer period to reinvest your funds and you don’t need to use an intermediary to hold your funds.

The Downside of 1033

Here’s the downside of 1033. In order to do a 1033 you must have had an involuntary loss. Commonly this arises in the context of a condemnation proceeding started against you or knowledge of a credible threat of condemnation. The problem is that many municipalities are leery of starting an actual condemnation - they don’t want the litigation headaches. Instead they want to negotiate with the seller to come to an voluntary and mutually agreeable price. If you’re negotiating, it’s hard to say that you’re selling under threat of condemnation. So many people who are dealing with government bodies will set the transaction up under 1031 – and if it qualifies for 1031 great. As a backup they can have a 1033 to fall back on.

Get Something in Writing

Mere saber-rattling by the government authority (“well we could condemn if we wanted to…”) probably doesn’t qualify as a credible threat. So I advise people to do the 1031 exchange or get something substantive from the government entity that they will condemn. For example, if you can get them to put a representation and warranty in the purchase agreement that the government authority can and will condemn if this purchase agreement is not accepted then you’ve got something authoritative in writing that you can rely on for your 1033. Absent credible evidence that the governmental agency has the power to take the property and has in fact made an actual imminent threat to take the real property you’re better off structuring as a 1031.

Another consideration for owner-operators (owner-user), that run a business out of their condemned relinquished property is that the like-kind standard under 1033 may require them to purchase a replacement property that is “similar or related in service or use” to their old relinquished property.  This requirement under 1033 that the replacement property be functionally equivalent is a much more exacting standard than the broadly construed like-kind standard for real estate under 1031.  Rev. Rul. 64-237, 1964-2 C.B. 319, states that, with respect to an owner-user, property is not considered similar or related in service or use to the converted property unless the physical characteristics and end uses of the converted and replacement properties are closely similar.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Requirements for Taking Title to Your 1031 Exchange Replacement Property

In order to qualify for a 1031 exchange, a taxpayer must have held their old property for investment or business purposes. But how exactly can you take title to your new replacement property? There are a few methods, which we’ll explain in this article.

Basic Requirements

The basic requirement is that the same taxpayer that disposed of the old Relinquished Property should be the party to use their exchange funds to purchase the new Replacement Property and the same taxpayer should take title to the new Replacement Property.  That way there is a continuation of investment by the same taxpayer and the “exchange” is completed into the new Replacement Property.  If a different taxpayer were to receive title on the new property, then the IRS would not view that as an exchange and would not allow the taxpayer who sold the Relinquished Property to defer their gain because they would not have completed an exchange with their exchange funds.

This is a complex area of law, and it’s important to have a skilled QI on your side to make sure you have all of your bases covered during your 1031 exchange.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved