June 2nd, 2021, by Leeron Hoory
President Biden’s new tax proposal includes restrictions on the 1031 exchange, a tax law that allows investors to defer paying capital gains tax on their property when purchasing a similar property shortly after. Under the current proposal, sellers would pay capital gains tax on profits over $500,000. This proposed tax change is part of Biden’s larger American Families Plan to raise $1.8 trillion dollars for education and child care.
The 1031 exchange — also known as the like-kind exchange — has been around for the last century, and it allows investors to roll their profits on a property into a new one when bought shortly after, which is sometimes used during estate planning. Currently there is no capital gains tax on profits from 1031 exchanges, no matter how high the amount. Congress’s Joint Committee on Taxation estimated that tax deferral on like-kind exchanges would save investors $41.4 billion between 2020 and 2024, Bloomberg reported.
Several commercial real estate professionals said limiting the exchange would negatively impact trade, and could have negative consequences on the industry — and economy — as a whole.
“Whether you’re a buyer, a seller or an investor, you’re going to be impacted by the increase in taxes that Biden is proposing,” Tim Koltermann, Chief Investment Officer and Partner at RockStep Capital, told lev.co. “It’s a big deal. His proposal is all-encompassing and may dramatically change the attractiveness of investing, which ultimately is counterproductive to getting the economy going.”
This law has long served as an incentive for investors to buy and sell properties. 6% of commercial real estate deals — and 10% to 18% of deals in high-tax states — make use of the 1031 exchange, according to one study by the University of Florida and Syracuse University’s Whitman School of Management.
Who Will be Most Impacted?
“Typically, the people who most benefit from the 1031 exchange laws are those who have owned a piece of property for many years and have a low tax basis,” said Scott Franklin, an attorney whose practice includes commercial real estate law. “If they sell the property outright, they will pay capital gains tax on the gain, whereas, if they use the 1031 exchange vehicle, they can roll over all of their gain to another property.”
As an example, Franklin said he recently completed a $6 million commercial real estate transaction for a seller who inherited the property from her father. The client purchased a property out of state, and was able to utilize the 1031 exchange, thereby delaying paying tax on her capital gains.
This change would likely impact the individual investor the most, said Rob Beardsley, who oversees acquisitions and capital markets for Lone Star Capital.
“The 1031 exchange is really big for individual investors or families that have real estate as their family business,” he said.
Beardsley noted that major real estate investment companies tend not to rely on 1031 exchanges as much as smaller investors. The recent report by the Joint Committee on Taxation stated that corporations will save $2.3 billion dollars, while individual investors will save $5.7 billion in tax advantages afforded by the 1031 exchange.
Greg Corbin, the President of Bankruptcy and Restructuring at Rosewood Realty Group, told lev.co that abolishing the 1031 exchange will “directly impact real estate investors’ ability to build equity and long-term wealth.”
“The 1031 exchange equally benefits all individuals who buy and sell property. It is a widely used mechanism for both large landlords and mom and pop investors alike to preserve their financial gains from a sale by purchasing other property.”
Restricting the exchange would reduce trades, impacting industry professionals who manage these deals.
“I think most brokers see that in about 30% or 40% of their transactions either one or both of the parties are participating in or planning a 1031 exchange,” Corbin said. “But long term, 9 out of 10 properties bought through a 1031 are eventually liquidated in a taxable sale.”
The exchange generates 568,000 jobs and $55 billion dollars annually, according to a study by Ernst and Young, in partnership with the Section 1031 Like-Kind Exchange Coalition, on the impact the 1031 exchange will have on the U.S economy in 2021.
“If transaction volume is substantially reduced, it will drastically cut into the livelihood of lawyers, investment sales brokers, title insurance agents, and mortgage brokers,” Corbin added.
The Ernst and Young study demonstrated that 1031 exchange laws support many industries, including leisure and hospitality, as well as trade, transportation and utilities. The study estimated that in 2021, 120,000 jobs will come from leisure and hospitality — 84,000 from businesses making use of the 1031 exchange and 36,000 from suppliers and retail consumer spending.
Eliminating the 1031 exchange, Corbin said, “not only serves as a financial blow to these individuals but reduces the tax revenue from their annual earnings. Additionally, fewer trades will further reduce revenue to the government in the form of transfer tax, recording fees, and mortgage tax.”
Taxpayers who make direct use of the exchange will pay an estimated $3.1 billion in federal, state and local tax in 2021, and suppliers to these businesses an additional $2 billion, the EY study stated.
Industry professionals also said that limiting the 1031 exchange could have a detrimental effect on the capacity of owners to maintain properties they are no longer incentivized to sell. In scenarios like these, an owner would hold onto their property rather than buy a new one, and the burden of disrepair would fall on the tenants.