1031 Exchanges were targeted this election, are they worth saving?
IRS Section 1031 Like-kind exchanges have been part of the U.S. Internal Revenue Code since as far back as 1921. They allow real estate investors to defer capital-gains taxes when they sell properties by directing the proceeds into new real estate investments. This saves millions in taxes annually and proponents argue that it helps to stimulate the economy by encouraging real estate investment.
However, because of their tax saving power, 1031 exchanges are often targeted as tax ‘loopholes’. Those who oppose their use argue that they only benefit ‘rich’ real estate investors and don’t benefit the average taxpayer. This argument is back in the news this election cycle. As part of his overall tax plan, Joe Biden has proposed to drastically reduce the use of 1031 exchanges by limiting them to investors who make less than $400,000 annually. He says he wants to use the reductions in tax deferral, and presumed increase in tax revenue, to help fund the extended budget deficit created by the pandemic.
Many economists and real estate industry experts argue that eliminating 1031 exchange will not create the desired increase in tax revenue because it will drastically reduce the volume of real estate being sold. If an investor has a highly appreciated property, the tendency will be to hold that property rather than sell it. If the property doesn’t get sold, there are no taxes to be paid. Additionally, the reduced sales volume will ripple throughout the economy in the form of reduced new development, and reduced jobs.
This topic has been widely studied. In 2015, the Alternative and Direct Investment Securities Association commissioned a study titled “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate” their conclusion stated:
“Overall, our analysis suggests that the cost of like-kind exchanges is likely largely overestimated, while their benefits are overlooked. The elimination of real estate exchanges will likely lead to a decrease in prices in the short-run, followed by an increase in rents in the longer run. These negative effects will be more pronounced in high tax states. Elimination will also likely produce a decrease in real estate investment, increase in investment holding periods, and an increase in the use of leverage.”
Other industry experts have weighed in on this topic recently as well. In an interview with TRD National, Stuart Saft – head of the real estate department at the law firm Holland & Knight, stated “They’ve talked about getting rid of 1031s for years, so I’m not surprised it would be in the Biden plan, however whenever Congress looked at these things, it’s been preserved.” He contends that 1031 exchanges have an overall positive impact on the economy.
For real estate investors, this topic should be top of mind this November. If you own appreciated property it would be wise to get educated on the pros and cons of this argument and research it for yourself.