In July 21, 2020, a senior campaign official for the Biden administration mentioned to Bloomberg a vague intention to limit the use of 1031 exchanges for real estate investors over a certain income threshold. Lost in the chaos of a COVID-19 summer, there hadn’t been any further mention of a proposed change to the 1031 parameters mentioned by then candidate and now President Biden. Still, considering the popularity of the like-kind exchange strategy among investors, and the pandemic driving federal deficit spending to new heights, the question is never too far from the minds of active investors.
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The rollout of the Biden/Harris American Families Plan brought the question back into headlines. With a $775 billion price tag, the Biden campaign pointed to the aforementioned restriction on 1031 exchanges as a potential tax change, among others, that could finance the plan.
The proposal promises universal preschool, financial assistance to help families secure childcare, increased pay for caregivers and educators, and an investment into home and community services under Medicaid. It would have the potential to add 3 million jobs in the care, community health workers, and early education sectors. Among potential funding strategies, the Biden administration mentions an increase to the top personal tax bracket and an increase to the dividends tax rate for households exceeding an income of seven figures. But it’s the proposed change to Section 1031 that’s caught everyone’s attention. Here’s why.
Where Section 1031 Comes From
Section 1031 is a segment of the Internal Revenue Code that allows a tax-free swap of qualifying, like-kind properties held for business or investment purposes. The tax deferral strategy, introduced in 1921, allows property investors to change the form of their investments and defer their payments on capital gains.
On first glance, the benefit to investors is clear—like-kind exchanges are used widely across the industry, from serial commercial real estate investors to highly involved, single-property landlords. But with a more detailed understanding of Section 1031 and its hundred-year-long history, it becomes clear that the real estate sector also benefits from like-kind exchanges. In fact, the negative consequences of passing a bill like 1031 could far outweigh the benefits and the tax recovered for a number of reasons.
First, properties that are bought using Section 1031 rules are more likely to include property improvements. Investors spend up to 40 cents more per square feet on those properties compared to purchases made through ordinary sales. Beyond their ability to encourage investment, like-kind exchanges lead to job creation and economic stimulation; in order for the use of like-kind exchanges to be repealed, the resulting recovery of tax revenue would have to outweigh the above benefits.
Showing the Math
A study conducted in 2015 by David Ling and Milena Petrova uncovered an important part of the equation. The two researchers were able to first disprove the notion that like-kind exchanges result in any permanent deferral or avoidance of tax. On the contrary, 88% of exchanged real estate properties ended up in a taxable sale. Further, a crucial regulation of Section 1031 is that replacement properties must be valued at a greater or equal amount than the property being exchanged. In effect, investors are trading up and improving their properties, generating more dollars in tax revenue on the final sale.
There remains a misconception that Section 1031 offers a tax break to wealthy investors only. On the contrary, one of the largest losses incurred by the 1031 repeal would be retirement accounts. Pension funds, endowments, and IRA accounts hold real estate in the form of real estate investment trusts, many of which benefit from 1031 exchanges. And as more post-pandemic investors rely on the stability of the real estate market for their economic prosperity and retirement security, an elimination of the like-kind exchange strategy could go against one of the more fundamental pillars of the American Families Act, which is to ensure adequate care—both health and economic—for older family members.
Perhaps inspired by Ling and Petrova’s work, Ernst & Young conducted a study on the economic impact of the repeal in the same year. Considering the applications of the like-kind exchange rules not only in real estate but also in transportation and construction industries, they found conclusively that a repeal would result in less federal revenue, an unfair burden carried by certain businesses and tax payers, a decrease in investment action, a negative overall impact on the economy, and a potential loss in the US economy of up to $13.1 billion annually. Their findings showed that the higher cost of capital and higher burdens on transactions would cost more than it would recover in tax revenue overall.
Breaking it down further into what the Ernst & Young team called ‘Important Comparisons,’ they considered the estimated tax revenue over a ten-year span from 2014 onward, roughly $41 billion, against the estimated reduction of overall U.S. GDP, which was projected to be anywhere from $61 to $131 billion. Along with the reduction in GDP, they estimated investments would fall by $7 billion, and labor income would fall by $1.4 billion should a repeal be put in place. That those numbers held true in 2015 is all the more relevant considering the pressures of the pandemic that all sectors have endured, and the task of recovery that lies ahead.
The Likelihood of a Repeal: Deal or No Deal
Still in the proposal stage, the Biden/Harris plan hasn’t yet passed congress. If the proposed tax changes are passed, the effective date would likely be in the next tax year, with no retroactive penalty incurred for investors who have used the like-kind exchange strategy in recent years. Both industry experts and political observers are considering the chances of the repeal unlikely, believing that Congress will recognize the net negative effect that the 1031 change would have on the real estate industry and on the economy as a whole. There remains a small chance that the change could be put into effect, a particularly frightening outcome considering the need for economic activity and strength as we move into post-COVID repair.
