Many real estate investors are accustomed to buying and selling properties without having to pay taxes. More specifically, a provision in the current tax law allows investors to essentially exchange their property for another of “like-kind” and defer settling the tax bill, known as the 1031 like-kind exchange. President Biden’s new tax proposal seeks to abolish the right to this tax deferral on property investment gains above a specified amount.
THE PAST 100 YEARS OF THE 1031 LIKE-KIND EXCHANGE
For the past 100 years, the IRS has allowed real estate owners and investors to exchange investment property for other investment property and defer the tax on any unrealized gains. The government collects taxes only when a property is sold and not traded into a “like-kind” property.
This tax provision exists under Section 1031 of the U.S. Tax Code and is generally referred to as a 1031 like-kind exchange or 1031 exchange. In addition to deferring taxes on the gain in real estate value, a 1031 exchange also defers tax that would be due on the recapture of depreciation when you sell a property.
1031 exchanges provide an economic stimulus to the real estate industry by incentivizing property sellers to reinvest proceeds in other properties. Professionals that service real estate the real estate industry also benefit commercial lenders, real estate agents, insurers, attorneys, contractors, and many other groups.
BIDEN’S PROPOSED TAX LAW CHANGE TO ELIMINATE THE 1031 EXCHANGE
This past April, the Biden administration announced another part of its infrastructure and economic plan. Called the American Families Plan, the proposal provides $1.8 trillion of new spending in several areas. The plan aims to raise taxes on “wealthy” households, raising an estimated $1.5 trillion over the next decade to help pay for the increased spending. In addition to raising the income tax rate on the top 1% of earners and raising the capital gains tax rate on households making over $1 million, the proposal targets people who own and could benefit from a 1031 exchange.
The proposal would eliminate a 1031 exchange on properties priced above $500,000. Currently, it’s not clear if this limit applies per year or per property. The consensus seems to be that it will apply per transaction.
Some politicians portray 1031 exchanges as a tax loophole for the wealthy. While the proposed changes will impact large investors, they could also touch smaller landlords who have built equity over many years, perhaps even decades. Many of these folks are not the wealthy the politicians are aiming to hit with increased taxes, yet they will be caught in the crosshairs of the proposed change.
Further, large commercial real estate investors often use the additional capital saved by deferring taxes to invest in and upgrade abandoned or underused real estate (shopping malls or warehouses). The proposed tax law change could remove incentives for such reinvestment and materially impact the communities and people the American Families Plan and infrastructure plans intend to help. In addition, fewer deals will mean less spillover work/income for many direct and indirect real estate-related industries.
WILL BIDEN’S PROPOSED TAX LAW PASS?
The possible good news? The 1031 exchange has been attacked at almost every new tax proposal over the past 30 years and has survived. Since the Democrats hold only the thinnest of margins in the Senate, they’ll likely need every Democratic senator to vote in favor of the tax proposal.
Limiting the 1031 exchange could be a tough sell for senators from specific states, perhaps requiring concessions to get the legislation through. This proposal would contribute about $40 billion toward the $1.5 trillion in projected revenue. That’s less than 3%. Accordingly, the proposed limit on 1031 exchanges could be an easy one to pull as many lawmakers may not see it as worth the massive push-back they’ll surely face from the real estate industry.
The 1031 exchange has managed to survive for the past 100 years, in large part due to its substantial benefits. Any successful efforts to limit the ability to use this critical provision in the tax law could have far-reaching and unintended consequences on the economy and the many people who currently benefit from it.
DISCLOSURE & ACKNOWLEDGEMENT
The information included in this material is for informational purposes only and should not be relied upon for any financial or legal purposes. Arlington Capital Management Inc, dba Arlington Wealth Management (AWM) is an investment adviser registered with the U.S. Securities and Exchange Commission. Our registration with the SEC or with any state securities authority does not imply a certain level of skill or training, nor are we selling you any product. Rather, we are seeking to provide you with advisory services. Please consult with your own tax and legal advisers before investing. AWM cannot and does not guarantee the performance of any investment. Past performance is no guarantee of future results.