With the recent change of administrations earlier this year, real estate investors and landlords are on high alert for policy changes that could impact their assets.
Of particular interest is the 1031 exchange, which is once again on the chopping block. 1031 exchanges have been around for a hundred years and have undergone many changes over that time, including attempts by politicians on both sides of the aisle to not only weaken investor benefits but also seek their outright appeal.
Shortly after the adoption of the first U.S. income tax in 1918, Congress deemed it unfair to tax businesses and individuals who sell properties and reinvest the proceeds rather than spend them. The prevailing view, which has persisted over the next century, was that if a taxpayer receives nothing in the transaction to pay taxes on (funds are transferred to the new property rather than spent), no tax should be owed.
Enter the 1031 exchange, which involves selling an investment property and reinvesting the proceeds in a like-kind property while deferring capital gains and depreciation recapture taxes. In a traditional real estate transaction, an investor can expect a tax liability of as much as 40% of the taxable gain without accounting for property improvements and sales costs. Being able to defer taxes makes it possible for an investor to seek a different type of investment, diversify holdings, expand their portfolio or realign investments with long-term goals.
The Tax Cuts and Jobs Act of 2017 resulted in the elimination of the 1031 exchange for personal and business property, while very fortunately, preserving the 1031 exchange for business-related real estate, including rental properties. Eliminating 1031 exchanges completely would further disrupt the commercial real estate industry at a time when it already faces unprecedented challenges from the COVID-19 pandemic.
Potential Elimination Impacts
While it’s no surprise that the pandemic has had a devastating impact on our economy, growing shifts in our political environment toward aggressively pursuing tax increases on wealthier individuals in an effort to reduce the perceived widening income gap in the U.S. could impact the fate of 1031 exchanges. However, eliminating the 1031 exchange could disproportionately hurt smaller investors as many are not large institutions and are everyday people. Approximately four out of five individual taxpayers whose long-term gains are from real estate report an adjusted gross income (AGI) of $200,000 or less and three out of five claim AGIs of $100,000 or less.
Eliminating the 1031 exchange will also impact residential renters by reducing stock of apartment supply and create rising rental rates due to a supply and demand imbalance, worsening housing affordability at a time when both renters and owners are struggling to make rent and mortgage payments due to lost income from the pandemic. Apartment transactions account for nearly one-third of all 1031 exchanges. The loss of the 1031 exchange would greatly reduce incentives for developers to build more units due to loss of profitability and reduce real estate capital investment and development at a time when the U.S. is desperately in need of economic expansion.
A repeal could also negatively impact property values and would be felt most acutely in cities and regions where tax-motivated buyers are most active. State and federal governments could also face reduced revenues as there will be fewer sales transactions and less taxes would be collected. Markets with capped property taxes—for example, California—would experience a reduction in property taxes since fewer investors will sell and keep their older, lower property taxes in place.
Being able to do a 1031 exchange and defer capital gains taxes has long been a part of many people’s retirement plans, and an elimination of the 1031 could greatly impact the ability to enjoy retirement, as they will have less to invest and impact their lifestyle in the future.
As the U.S.’s spending mounts and deficits continue to rise, real estate investors should expect more efforts by politicians on both sides of the aisle to compromise and eliminate this valuable part of the tax code and should consider moving up their timetables or they may miss out on potential tax deferral benefits.
Paul Getty, CEO of First Guardian Group, is a licensed real estate broker in the states of California and Texas and has been directly involved in commercial transactions totaling over $3 billion in assets throughout the United States.