The Proposed Repeal of Section 1031: What It Means

Section 1031 of the Internal Revenue Code permits investors to defer paying capital gains taxes on the sale of a business or investment property by reinvesting the proceeds into a new, “like-kind” property. This allows for the continuous investment of capital, as the tax obligation is postponed. This tax deferral mechanism is the subject of legislative debate, with proposals seeking to modify or eliminate it.

The Current Repeal Proposal

Recent federal budget proposals include provisions to alter Section 1031. The administration’s 2025 budget proposal targets what it calls a “loophole” allowing investors to defer taxes indefinitely. The stated rationale is to increase tax fairness and generate an estimated $19.6 billion in revenue over ten years, as proponents argue the deferral disproportionately favors wealthy individuals and large corporations.

The core of the proposal is a cap on the amount of gain that can be deferred, rather than a full repeal. This plan would limit the deferral to $500,000 per taxpayer, or $1 million for married couples filing jointly, each year for real property exchanges. Any gain exceeding this cap would be immediately taxable, with a proposed effective date for exchanges completed in taxable years after December 31, 2024.

This approach represents a compromise that targets large transactions while preserving the provision for smaller investors. This is not the first time Section 1031 has been targeted. The Tax Cuts and Jobs Act of 2017 eliminated like-kind exchanges for personal property, such as equipment and art, while preserving them for real property, continuing a trend of narrowing the provision’s scope.

Tax Impact of Repeal on an Exchange

To understand the financial consequence of limiting Section 1031, consider an investor selling a property for $2 million. If their adjusted basis is $800,000, they have a capital gain of $1.2 million. Under existing rules, the entire gain can be deferred through a 1031 exchange, so no immediate tax is due.

A limitation would fundamentally alter this outcome. Under the proposed $1 million cap for a married couple filing jointly, the first $1 million of the gain could still be deferred. The remaining $200,000 of gain, however, would be subject to immediate taxation at the applicable long-term federal capital gains rate, which can be as high as 20%.

This results in an immediate federal tax liability of $40,000 on the overage. The investor would also face state capital gains taxes, and high-income investors might be subject to the 3.8% Net Investment Income Tax on the gain. The cash required for this tax liability reduces the capital available for reinvestment, impacting the ability to scale investments.

Economic Arguments for Preservation

Proponents of maintaining Section 1031 argue that it encourages economic activity by fostering continuous investment. The ability to defer taxes allows capital to remain in the market, flowing between investments without being diminished by a taxable event. This liquidity helps small businesses and agricultural producers upgrade facilities or relocate without a prohibitive tax cost.

The provision also supports a wide ecosystem of related industries, including real estate agents, title companies, and construction firms. Limiting the provision could lead to a contraction in the real estate market as investors hold properties longer to avoid taxes, a phenomenon known as the “lock-in” effect. This reduction in transaction velocity could lead to slower economic growth.

Advocates also contend the provision encourages community improvement. Investors using a 1031 exchange often acquire properties that require upgrades, leading to private investment in renovating the nation’s building stock. This can revitalize neighborhoods and increase property values, generating economic activity that may offset the revenue lost from the tax deferral.