2017 was another record year for 1031 exchanges. Tax reform spurred movement in the industry and the new law will greatly impact real estate and Section 1031. As we start this new year, here are some of the issues that will affect real estate and 1031 tax deferred exchanges:
Impact of the Tax Cut and Jobs Act on Sec. 1031
The Tax Cut and Jobs Act was signed into law on December 22, 2017, and took effect on January 1, 2018. It is a complex modification to the Internal Revenue Code that will take businesses and individuals some time to fully understand, notwithstanding that it became effective just nine days after the President’s signature.
The new law retains Section 1031 for real estate exchanges. However, Section 1031 may no longer be utilized to defer taxes for transactions involving personal property.
Real estate exchanges are subject to the same rules and regulations as under previous law. The 45 day identification and 180 day exchange periods remain unchanged, as does the role of the Qualified Intermediary. All real estate in the United States, improved or unimproved, also remains like-kind to all other domestic real estate. Foreign real estate continues to be not like-kind to real estate in the U.S.
Personal property assets that can no longer be exchanged include intangibles, such as broadband spectrums, fast-food restaurant franchise licenses and patents; aircraft, vehicles, machinery and equipment, railcars, boats, livestock, artwork and collectibles. Transition rules permit a personal property exchange to be completed in 2018 if either the relinquished property was sold or the replacement property was acquired by the taxpayer during 2017.
Full expensing. The full cost of tangible business use personal property assets such as heavy equipment, farm machinery, vehicles and hotel furniture can be written off in the year that they are placed in service by the taxpayer. Although tax can no longer be deferred through like-kind exchanges for these assets, the full expensing deduction can be used to offset any capital gain or depreciation recapture recognized in that same or future years. Full expensing is temporary; it will expire in 2022, and will be reduced to 80% for assets placed in service in 2023, 60% for 2024, 40% for 2025 and 20% for 2026. This deduction applies to both new and used assets acquired by the taxpayer.
Continuing risks to Section 1031 will come from potential shifts of power in the House and Senate and from efforts to correct flaws and make adjustments to the new tax law. Since the bill was not revenue neutral, and increases the deficit by almost $1.5 trillion over the 10-year budget window, any changes must be paid for with an offsetting reduction. The real estate industry and taxpayers successfully made the case that Section 1031 should be preserved since it stimulates the US economy and benefits taxpayers of all sizes. However, that message will need to be delivered again as pay-fors are sought for corrections and the make-up of Congress changes after the 2018 elections.
Thank you to all of our clients, referral sources, the Federation of Exchange Accommodators, and coalition partners, for all of the collective efforts to retain Section 1031 Like-Kind Exchanges. Without all of our voices informing Congress of the broad benefits of Section 1031, this important tool could have been eliminated in its entirety.
We are very grateful to all of the Members of Congress that listened, understood, and supported retention of Section 1031 in this tax reform bill.
Will You Pay Taxes in 2018 or 2019?
If a delayed 1031 Exchange begins in the latter portion of 2017, the exchange period may run into 2018. If the exchange fails or if the taxpayer (having a bona fide intent to do an exchange) receives cash boot in 2018, the 1031 regulations treat the exchange as an installment sale allowing the taxpayer to consider that the exchange proceeds were received (and are taxable) in 2018. However, in accordance with IRC section 453(d), a taxpayer may “elect out” of the installment method. By electing out, the taxpayer can recognize the gain in 2017 instead of 2018.
To elect out, the sale should be reported on Form 8949, Form 4797 (or both) and not on Form 6252. The election must be made by the due date, including extensions, for filing the 2017 tax return. For more information about the procedure and forms to use see IRS Publication 537 and consult with your tax advisor.
Taxpayers should consult with their tax advisors since tax straddling does not apply to all sales, and any gain attributed to debt relief will still have to be recognized in the year of sale.