Despite an array of challenges and unknowns investors face in 2023, this year will likely prove to be another strong one for 1031 exchanges. While high interest rates, persistent inflation, market volatility, and possible recession weigh heavily on the minds of many, there are reasons to believe that 2023 is an opportune time to sell investment property using a 1031 exchange.
As a refresher, a 1031 exchange is a strategy defined in Section 1031 of the Internal Revenue Code that allows investment property owners to sell property and exchange it for like-kind replacement property while deferring capital gains and depreciation recapture tax. 1031 exchanges are often used by owners who want to upgrade their properties.
In Favor of 1031 Exchanges
Several factors favor 1031 exchange activity in 2023, including:
Investment property owners who experienced exceptionally strong rent growth across many sectors in 2021 began to see a slowdown last year. And that decelerating trend is continuing this year. Also, property valuations across many areas of the country are declining or remaining flat.
Owners are recognizing rapidly rising asset prices may not occur again for some time, which is causing many to put properties up for sale so they can capture as much appreciation as possible. Motivated sellers can create an attractive environment for 1031 exchangers intent on acquiring replacement properties at attractive values.
Capturing Bonus Depreciation
Part of the Tax Cut and Jobs Act of 2017, designed to stimulate business investment, provided businesses the ability to deduct a percentage of the purchase price of an eligible asset upfront from the company’s tax liability. The legislation allowed 100% bonus depreciation up until January 31, 2023.
At that point, the depreciation allowance begins to reduce by 20% each year until it fully expires in 2026. With significant savings still available, 1031 exchangers can still recognize significant benefits from the bonus depreciation to offset taxable gains on the sale of other assets like a business.
2023 will see more of a wave as baby boomers retire (those born between 1946 and 1964), impacting a sizable amount of the 33 million small businesses across the United States. Boomers who own investment property as part of their business will be focused on preserving as much of the wealth they have accumulated as possible, and 1031 exchanges will play a role in protecting their heirs and estates from capital gains and inheritance tax.
The 1031 exchange is a powerful estate planning tool in that it allows for the transfer of property to heirs on a stepped-up basis, which in essence, eliminates the capital gains tax on the appreciated value accumulated over decades.
The Biden administration has proposed limitations on 1031 exchanges as part of its 2023 budget proposal. President Biden campaigned on the idea of changing current 1031 exchange rules to allow individual taxpayers to defer tax on gains only up to $500,000. This would severely limit prospective 1031 exchangers, especially those who have owned investment properties for 20 years or longer.
The 1031 exchange has endured similar attempts over the years to limit or even eliminate the tax benefits taxpayers have enjoyed for over 100 years. And chances are, the administration's proposal will meet strong resistance from both parties in Congress. Still, investment property owners desiring to defer tax on large gains and to protect heirs from inheriting heavy tax burdens may want to complete their exchange this year in the event legislative changes are forthcoming.
Collectively these four factors suggest that 2023 will be a strong year for 1031 exchange transactions, as this long-favored wealth-building strategy remains at the forefront of investment property owners’ minds.
If you have any questions about 1031 exchanges or are considering using an exchange, schedule a convenient time for us to contact you, and we can address your specific needs and options available to you. Please contact us today.