The Tax Cuts and Jobs Act Impact on 1031 Exchanges

The impact of the new tax law on 1031 like-kind exchanges was a major topic last year as the bill was in process of being created and debated.  In the end, like-kind exchanges for real estate property was preserved.  This has been a major tool since its inception in 1921 that is used by real estate investors to defer any tax gain on a sale. 

Tax-deferred exchanges for personal property, intangibles, and collectables were cut.  These types of assets no longer qualify for a 1031 exchange.  One unique beneficiary of like-kind exchanges with the old law was the sale of race-horses.  Some 1031 intermediaries made a career as owners bought and sold prized equines.

But just because you are only involved in real estate only and have no desire to send the old mare to your neighbor down the road for his kids, does not mean that you should ignore the impact of the new tax law on 1031s as this will impact certain real estate transactions.  Consider the issue of selling a piece of real estate that has a valuable franchise license attached to it, like a McDonald’s.  In many transactions, the ownership of the franchise license is being sold apart from the underlying real estate.  In some cases, the value of the entire transaction is heavily weighted upon the franchise value.  Because the franchise license is considered an intangible, it is not eligible for the 1031. 

Another issue is when real estate and personal property are sold together.  Personal property may include equipment, machinery, furniture, and fixtures.  Like real estate, a taxable gain can be triggered when personal property is sold.  To avoid the gain, the FF&E component should be structured as a separate exchange since it is not like-kind real property.  This can impact certain transactions involving items like restaurants, hotels, medical facilities, and factories that will contain a large amount of FF&E.  Previously, a multi-asset exchange structure allowed investors to allocate values to the different components of the exchange like the real estate, FF&E, and goodwill.  The client will seek replacement property that has similar like-kind characteristics, giving an opportunity to align values for favorable tax treatment. 

This allocation is the heart of the new challenge.  The federal capital gains tax rate on real estate is 15 and 20 percent, while the tax rate on a gain of personal property is 35 percent.  Since the gain on the sale of FF&E cannot be deferred any longer, sellers will want to try to maximize the real estate value allocation and minimize the FF&E.  The buyers will want to have the highest possible value to FF&E, since they receive a larger depreciation for write off benefits. 

In a perfect world, FF&E would be valued at or below its current adjusted basis, resulting in no taxable gain.  This assumes an objective market appraisal will justify the valuation.  If not, it may be more beneficial to consider shifting more value to goodwill as the tax rate on goodwill capital gains is lower than the tax rate on FF&E capital gains. 

The new law opens up the importance for realtors to not only negotiate the price for the transaction but to also negotiate the various components within that price.  Sellers will find it to their advantage to have more of the purchase price allocated to real estate while the buyers will want more allocated toward the FF&E. 

It is important for the lender or real estate professional to not give tax advice.  But it is important to have knowledge of the new law and understand how this may impact the tax situation of the buyers and sellers.  Assuming they can have appropriate tax counsel, which supplies the transaction parties with maximum real property values that can be determined, the buyer and seller will be able to make their best decision as they negotiate the sales contract.  As a lender, understanding how a transaction will impact your borrower or guarantor with future tax liabilities, is important in judging their ability to support the credit. 

Quick Bites:  Illinois is the second highest property taxed state in the country, behind New Jersey.  However even with all these taxes, and other forms of state revenue, the Illinois News Network reports each Illinois taxpayer is on the hook for $50,000 in unpaid pension and other liabilities. 

To combat the problem the Chicago Federal Reserve has published a formal proposal that real estate is taxed an additional 1% annually per year for the next 30 years.  The challenge with property taxes is they will reduce the value of real estate and increase the tax burden for those left in the state who do not migrate out.  Plus it does nothing to correct the ongoing spending problem evident there.