President Joe Biden’s recent tax proposal, part of his American Families Plan, includes a provision that adjusts a long-standing tax benefit for real estate investors. Known as 1031 or “like-kind” exchanges, the program allows investors to defer the payment of capital gains taxes when they sell property as long as they replace it with a similar property within a specified time period.
“Deferred payment of capital gains taxes by investors has been essentially around since the 1920s,” said Stan Freeman, president of Exchange Strategies Corp. in San Francisco, during a New York Real Estate Center webinar hosted by Michael Romer of Romer Dobbas LLP. “The rules were codified in the 1980s with established deadlines for the process.”
Investors can roll the profits from the sale of an investment property – not their primary residence – into a new investment property and defer the capital gains on the sale with a 1031 exchange. The funds from the sale of an investment property are placed in an escrow account for the next investment, which must be identified within 45 days of the sale. Investors can identify up to three potential properties and purchase one or more of them within 180 days to defer capital gains taxes. Investors can defer capital gains taxes indefinitely through continuous 1031 exchanges.
The new proposal, which has yet to be voted on, would limit the tax deferment to profits of $500,000 or less. Investors with a larger gain than $500,000 would be required to pay capital gains taxes on the profit above that limit. During his presidential campaign, President Biden proposed eliminating the 1031 exchange tax benefit entirely. The Biden administration also proposes raising the capital gains tax from its current top rate of 20% for the highest earners to 39.6%.
Potential Impact on Property Investors
Congress’ Joint Committee on Taxation estimated that if the 1031 exchange is kept in its current form, real estate investors could save $41.4 billion in capital gains taxes from 2020 through 2024.
For example, Freeman presented during the webinar, an investor with a $2 million commercial real estate investment who wants to sell it after seven years – when it is then valued at $5 million – would realize a $3 million capital gain. That entire capital gain could be invested into that client’s next property with a 1031 exchange. Without the 1031 exchange option, the seller would likely pay the current 15% federal capital gains tax, a state income tax, which, for example, in California would be 13%, plus the passive investment tax of 3.8% for a total of 31.8% or $954,000. If the 1031 exchange is capped at a $500,000 profit, the seller would pay taxes on $2.5 million of the profit or $795,000 at the above tax rate. However, Freeman mentioned, the taxes could be significantly higher if the capital gains tax rate is increased.
“The big impact of capping or eliminating the 1031 exchange is that the program incentivizes investors to invest more in commercial real estate,” said Romer. “It’s been a tool that helps both sophisticated investors and less sophisticated investors build wealth.”
Freeman anticipates that a rollback of the 1031 exchange would cause capital to “race out of the system” and reduce the number of transactions. Local jurisdictions would lose the revenue from the taxes investors pay on their rental income.
“This could have an impact on an already struggling commercial real estate sector because it will be a disincentive for investors to purchase bigger buildings,” said Freeman.
However, the impact may not be widespread. The National Association of Realtors estimates that approximately 12% of real estate sales were part of a 1031 exchange from 2016 to 2019. The survey also found that 84% of 1031 exchanges involved smaller investors in sole proprietorships (47%) or an S corporation (37%).
The next step for the proposal on the 1031 exchange is for it to become part of official legislation to be voted on by Congress. It remains to be seen whether the proposal will become part of the package in its current form, is adjusted or eliminated.