The End of 1031 Exchange? What Real Estate Investors Need To Know
President Biden is looking to partially eliminate 1031 – or like-kind – exchanges to help fund his $1.8 trillion American Families Plan. This cut would result in a capital gains tax on any 1031 exchange transaction where the profits exceed $500,000.
As a popular investment vehicle, 1031 exchanges made up about 12% of real estate sales from 2016 to 2019, according to a survey from the National Association of Realtors (NAR).
Who May Be Impacted
Investors most likely to utilize 1031 exchanges aren’t the big institutional buyers everyone associates with commercial real estate. Though Biden’s plan is to increase taxes on the big corporations and investors who are perceived to benefit from many tax loopholes, modifying 1031 exchanges in this way will actually impact smaller investors the most.
NAR notes 84% of 1031 exchanges are executed by small investors, including sole proprietorships (47%) and S corporations (37%). These are your savvy, everyday investors – including retirees – who own net lease properties, single-family rental homes, apartment buildings and condominium units.
What May Result
Here are some things you might want to consider if Biden’s tax proposal becomes a reality.
- Demand may decline significantly in the private sector as sellers may be unwilling to sell, opting instead to hold their properties for a longer period of time
- Investors and their teams may need to further analyze and scrutinize their property-related expenses to reduce their gains on a 1031 exchange
- Tenant in Common (TICs), condominiums and Series LLCs may become more popular as investors divvy up their properties to accommodate the new $500,000 threshold
- Interest may spike in Opportunity Zones and Qualified Opportunity Zone Funds, which offer investors other tax incentives
- It may become difficult to find low-maintenance properties, such as TICs or net leased assets, which have a more hands-off approach, to exchange into as you near retirement
- UPREIT exchanges, or Section 721 exchanges, may become more popular as they offer an exchange of property for units in a REIT
- Investors may rush to complete 1031 exchanges before the close of 2021
- A flurry of 1031 exchanges before the end of the year could increase supply in this exceptionally tight, ultra-competitive market.
- Investors may be discouraged from pursuing expensive coastal markets where they stand to make a hefty sum from exchanging into and out of single-family homes
The Many Benefits of 1031 Exchanges
Since the 1920s, like-kind exchanges have been a very popular investment strategy. Passive and amateur investors can build their wealth and expertise over time by, say, investing in a duplex or net lease property, watching their money grow, and then slowly trading into other income-producing properties that allows them to defer capital gains.
This cut won’t hit the big corporations on Biden’s radar. Rather, it will take away a benefit for smaller mom-and-pop investors who just want to make their lives a little easier by investing in real estate. For retirees, 1031 exchanges can also be an amazing supplement to their Social Security and retirement accounts.
Investors aren’t the only ones who benefit from 1031 exchanges. These transactions support about 568,000 jobs and generate more than $55 billion annually, according to Ernst & Young. They’re also a way to keep properties that may otherwise face blight through underinvestment or underutilization in good, working order.
With this in mind, eliminating 1031 exchanges would not just be a blow to investors, but could potentially affect the affordable housing supply as well. Plus, fewer real estate transactions mean less tax dollars to begin with – which would be quite counterintuitive to a plan aimed at collecting more tax dollars!
It’s understandable that investors will have questions, concerns and comments with 1031 exchanges on the chopping block. The best thing you can do – aside from talking to your planning pros – is not panic. Nothing is set in stone yet, and few investors have ever benefitted from rash decisions.
FBF is here when you need us. Our trusted advisors can walk you through Biden’s new tax proposal and any ramifications it may have on your existing holdings or future dealings. Give us a call today. We’ll be happy to go over everything with you.
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