Update 1031 Exchange: What 2023 Tax Reform Could Mean for NNN Investing & the 1031 Exchange

May 5, 2022

A lot has transpired in 2021 and 2022 that has slowed the current administration’s tax reform plans, but changes are still on the horizon for 2023. Released March 28, 2022, the FY 2023 Budget and Treasury Greenbook propose an increase in the federal capital gains tax and income tax rates, elimination of tax breaks for the wealthy, and 1031 exchange deferral limitations.

If passed, the tax reformation won’t go into effect until January 1, 2023, which means now is the time to follow through if you wish to trade one or more underperforming or high-maintenance investment properties for a low- or no-maintenance triple net lease investment and defer 100% of the federal capital gains tax without any restrictions. To ensure you can use the full tax deferral, complete all 1031s by midnight, December 31, 2022.

The following information is a snapshot of the proposed FY2023 tax reform plan and what it might mean to you and your investment strategy.

2023 FY Budget Proposal & Tax Reform

The General Explanation of the FY 2023 Revenue Proposal is 120 pages long, so we thought we’d share a few of the tax reforms that impact high-net-worth individuals and real estate investors here.

  • Revert the top individual income tax rate for incomes above $400,000 from 37% to the pre-Tax Cuts and Jobs Act level of 39.6%.
  • For those with income above $1 million, taxation of long-term capital gains and qualified dividends at 39.6 percent (up from 20%).
  • When combined with the net investment income tax (NIIT) on investment earnings, the top tax rate on long-term gains would nearly double from 23.8 percent to 43.4 percent.
  • Limiting the like-kind 1031 exchange tax deferral to an aggregate of $500,000 per taxpayer or up to $1M for married couples filing jointly.
  • Require 100% recapture of depreciation as ordinary income for certain depreciable real estate.
  • Levy a capital gains tax and estate tax on the same assets, eliminating the step-up in basis.

According to the Tax Foundation, Biden’s proposed capital gains tax rate would be the highest since the early 1920s. The Tax Foundation further implies this tax hike could have the same impact as it did then, decreasing capital gains tax revenues so much, the government had to start reducing the tax in 1922.

As for high-net-worth commercial real estate (CRE) investors who sell properties, in all but eight states, they must also pay a state income tax on top of federal and state capital gains taxes. When combined, the loss of capital could be significant.

Money going down a hole

What will Biden’s Tax Changes Mean for the 1031 Exchange?

When the federal capital gains tax and income tax rates increase, the 1031 like-kind exchange will be needed even more to keep CRE investors investing. However, due to the proposed FY 2023 budget, you may lose your right to defer certain tax payments on property investment gains of over $500,000.

Therefore, if you wish to use the 1031 exchange in its current form, with no deferral limit, you must have your 1031 exchange closed by midnight, December 31, 2022. Given the 180-day rule, it’s best to get your 1031 exchange transactions started now.

What will the long-term effects be of the 1031 exchange alteration?

Bloomberg cites a 2015 study that argues removing [or reducing] the 1031 exchange tax deferral “could have negative consequences, including reducing liquidity in the market because holding periods would increase. They [study authors] also suggested real-estate investment would decrease, property prices would fall in the short-term, and rents would rise in the longer term.”

Furthermore, according to the Ernst & Young (EY) Tax News Update, 1031 exchanges have been part of the Internal Revenue Code since 1921. “Limiting the benefit of deferral to the extent proposed by the Administration would curtail a time-honored tax-savings strategy whereby a taxpayer may exchange appreciating real estate on a tax-free basis throughout his or her life while borrowing against the value.”

The EY report continues, normally, “Upon the taxpayer’s death, the heirs will take a stepped-up FMV basis in the real estate, and the appreciation will have escaped taxation completely. In this regard, the proposal to reduce the benefit available from deferral under IRC Section 1031 appears redundant, given the administration’s proposal to also subject the appreciation inherent in one’s assets upon death to income tax. In addition, when real estate is evenly exchanged and gain is recognized under the proposal, taxpayers may find themselves facing a tax bill with no corresponding cash generated from the transaction.”

To another Ernst & Young study, “In 2021, 1031 exchanges produced 568,000 jobs, created $27.5 billion of labor income, and add $55.3 billion to GDP.” If real estate investors stop investing, these figures will diminish. Additionally, small businesses with plans to expand would also be affected, as they would no longer benefit from the tax deferral to grow into a larger space, thereby slowing growth.

Overall, if this tax reform goes through, savvy investors will likely hold onto their real estate, ultimately providing less tax revenue for the government even though the tax rate is higher. Altering this time-honored tax rule will have a ripple effect throughout the economy.

Capital Gains Tax Implications & Step-up in Basis

If Biden’s new tax policies pass Congress, selling investment properties with over $500,000 in profit without the 1031 exchange tax deferral will be costly for investors (43.4% federal capital gains tax). It is also important to look at what this would mean if you were to inherit an investment property.

Currently, when you inherit a property, there is a step-up in basis, which means its value is increased to fair market value, and any capital gains that occurred during the decedent’s life go untaxed. As an heir, if you sell the property, the capital gains tax is assessed on the step-up in basis.

For example, if a property was originally purchased for $500,000 and it was stepped up in basis to $1.5 million (fair market value), then you sold it for $2 million, you would pay capital gains taxes on $500,000 profit. If you use a 1031 exchange to trade up to a different, like-kind property, the federal capital gains tax (approximately 20%) is assessed at the new basis and deferred.

By contrast, under Biden’s plan, The Tax Foundation reports, you not only pay taxes on unrealized gains while alive, but your heirs would also have to reconcile the pre-payments and deal with paying up to a 61 percent effective tax rate on unrealized gains at death, eliminating the step-up in basis.

Remember, you will not be able to use the 1031 exchange to defer the capital gains tax and buy another investment property as the profit from the sale would be over $500,000.

Additionally, for those with income above $1 million, taxation of long-term capital gains (on property held over one year) and qualified dividends will be levied at 39.6 percent, up from 20 percent. When combined with NIIT, the top tax rate on long-term gains could be as much as 43.4 percent.

According to the Tax Foundation, “Raising taxes on capital gains would reduce the incentive to save by reducing the after-tax return to saving. Lower domestic saving leads to lower income for Americans in the future and can lead to lower output by reducing domestic investment. In addition, there are administrative, structural, and transition issues that Biden will need to consider [when he] eliminates step-up in basis.”
defer capital taxes with 1031 Exchange

Depreciation Recapture Changes

Currently, you can recognize a gain or loss when you dispose of an asset used in a trade or business. When the sale price of a property exceeds the tax basis or adjusted cost basis, the difference is “recaptured” by reporting it as income. This can be considered a capital gain, an ordinary gain, or a long-term gain depending on the IRC tax code related to your situation.

The proposed change to this tax code is on Section 1250 real estate, which includes depreciable real property such as commercial buildings, warehouses, and rental properties. According to The General Explanation of the FY 2023 Revenue Proposal, “Applying 100 percent depreciation recapture to the cumulative depreciation deductions on section 1250 property would eliminate this tax subsidy and opportunity for conversion of income. The proposal would not apply to noncorporate taxpayers with adjusted taxable income (AGI) below $400,000 ($200,000 for married individuals filing separate returns).”

Currently, in a 1031 exchange, not only can you defer the capital gains tax, but you may also defer the depreciation recapture tax, which can provide an additional savings of 25%. When coupled with the capital gains deferral, a significant amount of capital can be freed up to reinvest. Under the amended section 1250 depreciation recapture tax code and with the new 1031 exchange tax deferral cap of $500,000, most wise investors will not sell or trade unless they must because the loss of working capital will be too great.

The Future of NNN Investing Under the Current Administration

For decades, the triple net investment market has been stable. We’ve seen supply and demand fluctuate because of the pandemic, and cap rates remain favorable with slight compression throughout the recent economic uncertainty. Now, with historical capital gains and income tax increases, a 1031 exchange deferral cap, and other important tax changes on the horizon, we predict NNN investing and 1031 exchanges will have an urgency not seen in modern times.

So, what does the future of NNN look like? Stable. Essential businesses such as dollar stores, convenience stores, fast-food restaurants, auto parts stores, retail pharmacies, and medical clinics are still adding locations, relocating, and making properties available to CRE investors. In fact, many of these companies continue to see growth despite uncertain times, providing NNN investors with recession-proof properties that supply reliable, guaranteed income.

5 NNN properties

How Can I Get into a NNN Property Before the Proposed Tax Laws Take Effect?

If you are interested in purchasing a NNN property or you’re in the process of utilizing a 1031 exchange, there’s no time to wait. Some of these tax reforms may not pass, but some will, so December 31, 2022, is the date to remember if you wish to use any of the tax codes mentioned in this article before they change.

Moreover, given the tight NNN market and rising interest rates, the most reliable, and possibly the only way to buy a triple net lease property is to engage a specialized buyer’s advisor, like those at Westwood Net Lease Advisors. Since many properties are not making it on the open market and those that do are selling right away, we will help you navigate the tax rules and find exactly what you’re looking for. Our advisors are well-known in the industry and connect with sellers daily before their properties hit the open market.

To Wrap it Up – What NNN Investors Need to Know About Biden Tax Policy Changes

As a current or future NNN investor, it’s important to be aware of Biden’s tax-policy proposals and what those could mean to your financial future. Some changes may not come to fruition, while others may, but without knowing, it’s wise to start your real estate buying, selling, and 1031 exchange transactions as soon as possible and complete them by December 31, 2022.

The easiest way to invest is to reach out to Westwood Net Lease Advisors for a consultation. We specialize in NNN investment properties and 1031 exchanges and are happy to partner with your CPA or tax specialist to ensure your best interests are met. Our goal is to get you into the strongest, most profitable NNN investment with ease and help you reach your financial goals. Our buyer representation – from initial consultation through closing – is free. Contact us for a no-obligation conversation today. 314-997-5227


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