Whenever you sell businesses or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale.
IRS Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under Section 1031 is tax-deferred, but it is not tax-free.
The Biden administration has proposed limits to the 1031 Exchange (also known as a like-kind exchange) which may impact real estate investors.
Who qualifies for the Section 1031 exchange?
Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties under Section 1031.
Currently, when sellers complete a like-kind exchange, taxes are generally deferred until the next time he or she sells, which could be months later. There is also no limit to the number of times a person can exchange. This is a legal way for business owners and investors to reduce taxes, allowing for increased capital to reinvest.
For example, a real estate investor buys property for $1 million, which later sells for $5 million. By using the proceeds to develop a similar property, he or she defers paying taxes on the capital gain. This process can be repeated indefinitely.
The proposed plan eliminates 1031 exchanges for real estate investors in cases where the gains are more than $500,000. If passed, the plan would require investors to pay taxes on gains larger than the limits named above.
The proposed plan affects both wealthy corporations and individuals. Provided the Biden plan does not become law, the Congressional Joint Committee on Taxation estimates that the 1031 exchange may save real estate investors over $41 billion in taxes in 2020-2024.
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