The American Families Plan and the Erosion of §1031 Like-Kind Exchanges

Like-kind exchanges (current Internal Revenue Code Section 1031) have been an element of U.S. federal taxation since 1921. For the past 100 years, like-kind exchanges have been used to defer taxes on exchanges of like-kind property under a continuity of investment concept. However, no matter how sound the logical or policy argument may be, the breadth of deferral afforded by §1031 like-kind exchanges has increasingly been under attack.

In 2017, the Tax Cuts and Jobs Act (P.L. 115-97) limited like-kind exchanges solely to those exchanges involving real property. The definition of real property for §1031 like-kind exchange purposes suddenly became of utmost importance. As no such definition had ever been officially adopted, the Treasury Department issued taxpayer-favorable regulations near the end of 2020 (Treasury Decision 9935, and Treas. Reg. 1.1031(a)-3, effective December 2, 2020).

American Families Plan

Fast forward just a few short months, and §1031 like-kind exchanges are again in the crosshairs as details of President Biden’s proposed American Families Plan continue to emerge. Under his plan, Biden has proposed eliminating tax deferral for all §1031 like-kind exchanges where the realized gain exceeds $500,000.

When considered in connection with several of the other tax proposals within Biden’s American Families Plan, specifically (i) ordinary income tax rates on capital gains for taxpayers with income over $1 million, (ii) elimination of basis step-up at death and (iii) the elimination of carried interest treatment of partnership allocations, the ability to use §1031 like-kind exchanges (if retained) to defer and/or control the timing of gain recognition could become extremely valuable. Of course, this will depend on the extent these provisions are protected (or at least protected enough) in the inevitable political horse-trading that is about to ensue.

While it is unknown exactly what it will look like once the dust settles, the following are a few considerations for those with real property that could be the subject of a §1031 like-kind exchange:

1. Capital gain tax rates are likely going up, and other deferral mechanisms are on the chopping block. If the §1031 like-kind exchange escapes largely unscathed, its value as a tax planning tool increases as capital gain rates/other deferral mechanisms are increasingly impacted.
2. For taxpayers currently exchanging or considering §1031 like-kind exchanges, proceed with caution.
   1. The actual thresholds (i.e., gains exceeding $500,000 in the original proposal) are subject to change.
   2. Perhaps even more critically, taxpayers must consider and understand the effective date of any law changes. Taxpayers attempting to squeeze in a §1031 exchange before the end of the year (perhaps under an assumption that effective dates would default to January 1, 2022) could be surprised should Congress choose an effective date that precedes completion of the exchange. What the taxpayer expected to be a tax-free §1031 like-kind exchange could end up being taxable, and even more painfully, possibly taxed at a much higher capital gains rates. There is a chance relief will allow taxpayers to complete §1031 like-kind exchanges that have already been initiated, but this remains to be seen.
3. States may or may not adopt possible changes, and §1031 like-kind exchanges may retain value from a state tax perspective.
4. Other tax deferral strategies may take on additional significance.

Whether you are in the midst of an exchange, are contemplating one in advance of possible future law changes or are wondering if an exchange is something you should consider, this proposal could impact you.

For questions or assistance determining the potential impact of these changes, contact Armanino’s tax experts.