Whitman Legal Solutions, LLC

In Sizing Up in Violins and Investment Real Estate, I talked about how Section 1031 exchanges can, over time, help real estate investors increase the value of their holdings. I likened the real estate investor’s experience to my own experience in gradually increasing the quality (and price) of his violins as he grew older and his violin playing advanced.

We had just purchased my son’s most expensive violin yet–a 7/8 size Czech violin made in 1820. That violin cost over 20 times the price we paid for my son’s first violin nearly nine years previously at age three–a tiny 1/32 size violin, which with an eight-inch body looked more like a toy than a violin.

By the time our son moved to a 1/10 size violin, his playing had advanced to where we moved up a step in quality (and therefore, price). Each time, we sold (or traded) the smaller violin for a larger one. And each sizing up, through 1/8, ¼, ½, and ¾ size violins, also included a step up in price with each successive instrument. So, the price of the 7/8 size violin wasn’t too much of a shock.

How Real Estate Investment is Like Buying Violins

Real estate investors also frequently gradually increase in size and price of their assets. A real estate investor might start small with a single duplex. When they sell the duplex, they might reinvest in a more expensive 40-unit apartment complex, and so forth. Eventually, through a series of purchases, sales, and reinvestments, the real estate investor may own multiple apartment complexes totaling 1,000 or more rental units.

One thing that helps real estate investors grow their portfolios is Section 1031 like-kind exchanges. Using a Section 1031 exchange, investors can defer taxes each time they sell an investment property and reinvest the proceeds in another “like-kind” investment property within 180 days. There is no limit to how many times an investor could do back-to-back Section 1031 exchanges.

Violins differ from real estate investments because there is a limit to how many times a violinist can “size up” their violin. Nearly two years after we purchased the 7/8 size violin for our son, he increased his violin one last time–to a full-size violin. Once a violinist reaches a full-size instrument, they play on that size instrument for the rest of their life.

Real estate investment strategy often has no fixed end. Frequently, the strategy to do successive Section 1031 exchanges until the investor’s death. Then, the investor’s heirs receive a stepped-up basis, eliminating the need to pay income taxes on the gain. And with high estate tax exemptions, frequently, there are no estate taxes either.

However, the Biden administration’s tax plan includes eliminating the stepped-up basis. Plus, there has a suggestion to eliminate Section 1031 exchanges for taxpayers with more than $400,000 in annual income. With these tax law changes possibly being on the horizon, like violinists, real estate investors may find there is an upper limit to their ability to “size up” investments. And many real estate investors may need to rethink their “exchange until you die, then stepped up basis” investment strategy.

Tax Concerns Upon Sale of Real Estate Investments

Unlike violinists, real estate investors have to consider taxes with every “trade up.” There are two main ways that an investor might owe taxes when they sell investment real estate:

  • Appreciation or increase in value (i.e., the property is sold for more than what is invested in it) and

  • “Recapture” of depreciation expenses that the investor took while he/she owned the investment real estate. Although land cannot be depreciated, buildings can be, so there can be a significant tax liability upon sale of the investment.

Real estate investors aren’t the only people who have to worry about taxes when they sell real estate. Homeowners who sell their residences for more than invested also may find themselves with a big tax bill. But since homeowners can’t depreciate their homes, they need be concerned only about capital gains tax.

Homeowners have relief that real estate investors don’t. If an individual sells their primary residence, the first $250,000 of their gain is exempt from capital gains taxes. For a married couple filing jointly, the exemption is $500,000.

Similar to successive 1031 exchange strategy, homeowners can buy and sell successive primary residences and exempt $250,000 of that gain for each sale. But they can only do this once every two years. Like real estate investors, homeowners’ heirs will receive a stepped up basis when the homeowner dies.

History of Section 1031

When it was first created in 1921, a Section 1031 exchange required a literal swap of the two properties, as would occur if my son were to literally trade in his tiny violin at the violin shop for a larger-sized violin. For a direct swap, tax deferral makes sense. 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 could be used to pay taxes.

However, most people don’t literally swap real estate. Instead, they sell one property and use the proceeds to buy another. Therefore, over the years, Section 1031 exchanges have evolved to be more beneficial to real estate investors.

For the past 30+ years, the tax law has included a safe harbor if real estate investors use a “qualified intermediary” to hold the property sale proceeds until the investors buy a new property. This is roughly the equivalent to selling the smaller violin to another student, then putting the proceeds of the sale in a special savings account (like a qualified intermediary) that could only be used to buy a new violin when the violinist found the violin they wanted.

History of the Stepped Up Basis

Rather than being related to income tax, like Section 1031, the stepped-up basis on death is related to estate taxes. At the risk of oversimplifying, the estate pays taxes on the entire value of the decedent’s estate. So, when a real estate investor dies, there is estate tax on 100% of the value (not just the capital gain or recaptured depreciation). Since estate tax has been paid on 100% of the value of the real estate, it makes sense to reset the heirs’ basis, so it matches the value on which estate taxes were paid.

But like $250,000 of a homeowner’s sale of their primary residence is exempt from capital gains tax, the first part of an estate is exempt from estate taxes. This wasn’t a big deal in the 1970s when the estate tax exemption was less than $150,000. However, that exemption gradually increased to $1 million in 2002. Then, in 2010, there was a big jump to $5 million. In 2017 there was huge increase in the exemption to $11.8million, and in 2021, it is $11.7 million.

With such a high estate tax exemption, few estates pay any tax. And if estate tax hasn’t been paid on real estate, the stepped up basis admittedly doesn’t make as much sense. However, the estate tax exemption increase was temporary and is set to expire in 2025. If this happens, the stepped-up basis will once again serve a logical purpose.

How Might the Biden Tax Plan Change Real Estate Investment Strategy?

There are three ways the Biden tax plan might affect the “exchange until you die, then stepped up basis” investment strategy:

  • Reduced availability of Section 1031 exchanges

  • Elimination of the stepped-up basis upon death

  • Reduced availability of long term capital gains tax rates

Reduced Availability of Section 1031 Exchanges

Section 1031 exchanges frequently are targeted for dilution or elimination because many people view them as a rich person’s tax loophole. But 1031 exchanges enable beginning investors who may buy a duplex and live in half and rent the rest to grow their wealth by buying successively larger properties. And by increasing their wealth over time, by the time that duplex investor retires, they may depend on their real estate investments to support them in their retirement.

The Biden tax plan could phase out Section 1031 exchanges for taxpayers with more than $400,000 in income. The devil is in the details -- and what is counted to determine if the taxpayer has $400,000 in income. However, it will be challenging to craft a program that doesn’t impact retirees and other taxpayers who aren’t wealthy.

Suppose a business owner purchased a building for $400,000. They use the building for their business for 25 years and depreciate it down to a zero basis. Selling the business real estate is part of the owner’s retirement plan. The business owner also expects to receive $30,000 per year in Social Security, and $25,000 per year in earnings from their retirement accounts.

When the business owner is ready to retire, they sell the building for $750,000, expecting to do a Section 1031 exchange into income-producing investment real estate. If they don’t do a Section 1031 exchange, they will have $350,000 in long term capital gains and $400,000 in recaptured depreciation.

If the building sale proceeds are included in income, they would have over $400,000 in income in the year they sell the building. They could be barred from a Section 1031 exchange even though their sole income is from Social Security and retirement accounts.

The hypothetical business owner’s income prevented them from benefiting from a Section 1031 exchange. They would pay $70,000 in long term capital gains tax and approximately $134,000 in income taxes without considering the Biden tax rate increases. That would leave them with $214,000 less in retirement assets and $10,000-$12,000 less in annual retirement income than they planned.

Elimination of Stepped Up Basis

With the increased estate tax exemption sunsetting in 2025, taxpayers should expect that the estate tax exemption might be reduced to earlier levels. The Biden tax plan would have the exemption decrease to $3,500,000 immediately.

Plus, there is a proposal that the stepped-up basis be eliminated. If this were to happen, the estate could pay estate taxes on 100% of the value of real estate, AND later the heirs would owe long term capital gains taxes on any pre-death gains on the real estate for which estate taxes were paid.

Increase in Capital Gains Rate

In addition to increasing income tax rates for higher income taxpayers, the Biden tax plan would increase the long term capital gains tax from 20% to the much higher ordinary income rate, which would cap out at 39.6%. The current proposal would only affect taxpayers who make more than $1 million.

If adopted, this change would affect our hypothetical business owner if they sold the real estate for $950,000, rather than $750,000. Although $950,000 sounds like a lot of money, based upon a retirement income calculator, it would produce only about $38,000 in annual income for someone who retired at 67, placing them in the middle class.

What Real Estate Investors Should Do Now

If the entire Biden tax plan is adopted, the tried and true strategy of Section 1031 exchanges until death, and then a stepped-up basis may no longer be feasible for many taxpayers. Investors should evaluate their tax situations to determine if a change in plans is warranted. Although each taxpayer’s situation is unique, and we don’t yet know the exact tax changes, some strategies to consider include:

  • Gifting assets to take advantage of current high estate tax exemption rates

  • Changing depreciation strategy during the hold period to minimize gains upon sale

  • Accelerating disposition plans and complete Section 1031 exchange before any tax changes take effect

  • Not doing a Section 1031 exchange and paying long term capital gains rates now on gains

  • Installment sales to spread out income from dispositions

  • Section 1031 exchanges into several smaller assets or tenant-in-common or Delaware statutory trust investments, so Section 1031 will be available upon disposition.

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.

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