Although I was primarily a violinist, I also played the clarinet. When most people think of the clarinet, they think of the “standard” b-flat clarinet. But there actually are seven or eight different types of clarinets covering a wide pitch range.
Clarinets are transposing instruments, which means when the musician plays a C on that instrument, a different note sounds. The “common” clarinet is a B-flat soprano clarinet, which sounds a B-flat when the musician plays what is notated as a C.
However, there are two other types of soprano clarinets – A clarinets and E-flat clarinets, which have the same fingering configurations, making it easy for musicians to switch between instruments. A clarinets look and feel much like B-flat clarinets but play a semitone lower than a B-flat clarinet.
E-flat clarinets use the same fingering configurations as the other clarinets but are noticeably smaller and sound a fourth higher than a B-flat clarinet. Because of their small mouthpiece and keys, it’s difficult to play an E-flat clarinet in tune. And unless the clarinetist is careful, an E-flat clarinet can sound shrill and unpleasant.
Ever one for a challenge, I agreed to play both first B-flat clarinet and E-flat clarinet in my high school concert band. My violin ear training may have made it easier for me to play the E-flat clarinet in tune. But the E-flat clarinet’s mouthpiece was still a lot smaller than the one on the B-flat clarinet. Because of this, the E-flat clarinet required a tighter embouchure (mouth position) than my B-flat clarinet.
Perhaps over ambitiously, I agreed to play both instruments in the same band performance – and at a competition no less. Usually, the band played the piece where I played B-flat clarinet first. I had learned how to tighten my embouchure when I moved from B-flat clarinet to E-flat clarinet.
However, in the competition, the order of the pieces was switched, and I had to play the E-flat clarinet first. Once I became accustomed to the smaller mouthpiece, it was challenging to transition immediately to the B-flat instrument.
When a clarinetist plays with too tight an embouchure, a dry reed, or too much pressure on the reed, the clarinet makes a high-pitched squeak. Although that unpleasant clarinet sound is common among beginners, I wasn’t a beginner.
It’s no surprise what happened at that competition. I didn’t have time to wet my B-flat clarinet reed in between the pieces. And due to performance stress, I didn’t adeptly switch my embouchure when I switched from the smaller E-flat instrument to the B-flat one. The result was unattractive (and embarrassing) squeaks and a look somewhere between surprise and glare from the conductor.
Until now, like clarinetists who can switch between instruments without learning new fingerings, real estate investors have been able to use Section 1031 exchanges to switch between real estate investments and defer tax liability. However, if President Biden’s American Families Plan is adopted as proposed, like a clarinetist, real estate investors may find their ability to switch between investments is more like switching from B-flat to E-flat clarinet. Under the American Families Plan, if a real estate like-kind exchange isn’t carefully structured, investors may pay taxes on the switch.
This article is part of a series discussing how the American Families Plan might affect real estate investments. Previous articles discussed how the American Families Plan proposes eliminating the stepped-up basis for many taxpayers and changing taxes on long-term capital gains and carried interests. This article discusses lowering the estate and gift tax unified exemption and stepped-up basis.
History of Section 1031
When it was first created in 1921, a Section 1031 exchange required a literal swap of the two properties. For a direct swap, tax deferral makes sense because it’s often difficult to determine the “sale prices.” Plus, unlike a sale and reinvestment, a sale doesn’t result in a cash payout that an investor can use to pay taxes.
However, most people don’t literally swap real estate. Instead, they sell one property and use the cash they receive to buy another property. Over the years, Section 1031 exchanges have evolved to be more practical. For over 30 years, there has been a safe harbor for real estate investors who use a “qualified intermediary” to hold the property sale proceeds until the investors buy a new property.
The Section 1031 safe harbor (which most investors use) requires compliance with a strict process and time deadlines. But there is no limit on the amount of gain that can be deferred.
How the American Families Plan Would Change 1031 Exchange Rules
The American Families Plan proposes ending the ability for investors to use Section 1031 to defer taxes on gains greater than $500,000. As with all tax proposals, the devil is in the details. It’s unclear how the $500,000 gain would be calculated. It might be an annual limit for each taxpayer during a tax year. Or, it could be a transaction limit that taxes gains from any disposition if they $500,000 or more. Or, the limit could impose a $500,000 limit per year on the gain from any one property.
It’s also unclear whether, as with excluding gains from the sale of a personal residence, spouses could combine the limit. If that’s the case, then spouses could defer taxes on up to $1 million in gains.
How the American Families Plan Would Affect Ordinary People
Although the American Families Plan says it will keep wealthy people from benefiting from Section 1031 exchanges, those aren’t the only people who benefit from Section 1031. Section 1031 exchanges also help small business owners and farmers.
A recent Wall Street Journal article notes that farmers likely would be hurt if Section 1031 exchanges were limited. In 2017, farmers lost the ability to do Section 1031 exchanges to defer gains when they sell expensive farm equipment. If they also lost the ability to defer taxes on gains when farmland is sold, farmers might not be able to seek better land when theirs is no longer usable due to urban growth or environmental reasons.
Small businesses also use Section 1031 exchanges. Suppose someone starts a restaurant at a building they purchased for $200,000. They work hard a grow the business for 20 years, while the building increases in value to $1,000,000. The restaurant is successful, and the owner wants to buy a nearby, larger building for $1,500,000 to further expand. Currently, the owner could do a Section 1031 exchange and invest 100% of the proceeds from the sale of their original building to buy the new one. But under the American Families Plan, the owner must pay taxes on $300,000 of their gain (plus any additional recaptured depreciation).
Having to pay taxes on the sale of the restaurant’s business might reduce the owners’ cash to where it doesn’t make sense to expand. And any new employment positions that might have been created from the expansion won’t be needed.
How Limiting Section 1031 Exchanges Might Impact Commercial Real Estate
Because tax reformers frequently have targeted Section 1031 exchanges, there’s significant research about how like-kind exchanges affect the economy. According to a 2015 study, eliminating like-kind exchanges would cause commercial real estate prices to decline and would cause rents to increase. Although the American Families Plan doesn’t propose eliminating Section 1031 exchanges, the changes it imposes are likely to cause a similar impact to eliminating them.
If sellers must pay taxes on their gains every time they sell real estate, they will have fewer funds to reinvest in real estate. Plus, with no tax benefit in reinvesting in real estate, investors might consider reinvesting their real estate proceeds in other types of investments. The result will be less demand for real estate investments, which may cause prices to decline.
Like the restaurant owner, who may decide not to expand, real estate investors are likely to hold real estate for longer periods. This will reduce inventory in the real estate market. According to the 2015 study, longer holding periods correlate with lower capital expenditures, possibly because new owners frequently make upgrades shortly after acquisition. Lower capital expenditures may affect the demand for labor and supplies in the construction industry.
How to Plan for the Possible Tax Law Change
It’s impossible to eliminate the risk of a clarinet squeaking when switching to a smaller instrument. However, there are things the musician can do to minimize the risk.
Although we don’t yet know what changes will be adopted or how the proposed $500,000 exemption will be calculated, commercial real estate owners may be able to act now to minimize the impact of reduced availability of Section 1031 exchanges:
Real estate owners planning a sale and exchange in the next 12 months should speed up that timetable and sell now. Congress can pass retroactive tax laws. But Congress usually hasn’t passed laws that impose retroactive taxes on transactions structured specifically to comply with prior law because of the chaos that would result if taxpayers attempted to unwind transactions. Therefore, exchanges completed before Congress proposes specifics aren’t likely to be affected by a new law.
Real estate investors should invest smaller amounts in individual properties. By investing in more properties (but with a smaller amount of equity in each property), investors will be able to take advantage of the $500,000 exclusion more frequently (i.e., when each property is sold).
Consider paying taxes on gains now. Assuming Congress doesn’t retroactively change long-term capital gains treatment, investors may want to forgo Section 1031 exchanges when they sell real estate and pay long-term capital gains taxes on sale proceeds now. That will enable them to take advantage of current long-term capital gains treatment before it is changed. Although they will have less cash to reinvest, they will have a higher basis in their next investment. With a higher basis, a limitation on Section 1031 exchanges and future increases in long-term capital gains taxes likely will affect them less.
Taxpayers who haven’t done estate planning should do so now. Everyone should have a will, and everyone with a significant net worth should consider estate planning. Investors may structure ownership of their real estate through irrevocable trusts or implement a gifting plan and break their investments into smaller segments.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.