Presidential nominee Biden has rolled out his proposed tax plan with two major pillars that will impact real estate: 1) Elimination of the 1031 exchange provision 2) elimination of long term capital gains. These two changes, if passed, will have huge implications for taxes, real estate values, rental rates, employment growth, and real estate investing in general and Your taxes will increase $775 Billion dollars according to an analysis by Bloomberg. Furthermore, the fix and flip business will be eliminated.
What is a 1031 exchange?
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.
The 1031 exchange can be used for both commercial and residential investment property. For example, if you owned an industrial building, you could sell the property and “exchange” it into another property and defer the tax liability. The 1031 exchange does not eliminate taxes, it merely defers them to a later time.
There is a market misconception that 1031 exchanges primarily benefit large scale wealthy investors. The reality is that the majority of exchange transactions are under one million meaning the majority of the beneficiaries are smaller investors.
If the 1031 exchange were eliminated what is the impact on real estate and the economy?
In 2015 there was a proposal to eliminate the 1031 exchange. A study was done by professors at the University of Florida to understand the true impacts of the 1031 exchange and the implications on the benefits of a program. Below are some of the key findings
We also develop a “typical project model” to estimate the range of short-run declines in
prices that would be necessary to offset the increased tax burden of eliminating like-kind
exchanges. In local markets where investors are moderately taxed, we estimate that prices on typical office, industrial, retail and other commercial properties would have to decline eight to 12 percent to maintain required investment returns. In the longer run, rents would need to increase from eight to 13 percent to offset the effects of elimination. Price and rent effects would be more pronounced in high-tax states.
In addition to using some of the deferred gains to increase the size of their investment
in subsequent properties, investors in like-kind exchanges use less leverage than ordinary investors to acquire replacement properties.
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.
These micro effects are likely to have macroeconomic consequences as well. For example, a reduction in real estate activity, resulting from lower investment and prices decreases, would lead to slower growth rate in employment, especially in the markets where like-kind exchanges are commonly used.
Long term capital gains also eliminated leading to a huge increase in taxes
The fallback for elimination of the 1031 exchange would be to hold the property for 18 months to get a lower capital gains tax rate of as low as 15%. Unfortunately, the long term hold strategy is also going by the wayside.
Biden’s plan would raise taxes on capital gains by treating them as ordinary income for those earning more than $1 million. On his website he said he would also raise the top rate on ordinary income back up to 39.6 percent from the 37 percent rate put in place by the Tax Cuts and Jobs Act and adds a Medicare surcharge. As such, the top rate on long-term gains would nearly double from 23.8 percent to 45% percent.
Largest impact on commercial properties
Commercial real estate is already on track for a very challenging year with higher cap rates and reduced lease rates, adding on profound change like the elimination of the 1031 exchange will be catastrophic for many property owners. For example, let’s say someone owned an office property, with everything going on, the owner would likely be inclined to exchange into another more productive property like industrial. With the elimination of the 1031 exchange, the property owner could be facing a tax bill up to 40% so they make the decision to hang on to the underperforming property. The subsequent economic impacts are that capital is not optimally utilized. Furthermore, banks, title companies, realtors, exchange companies, contractors, etc… are also going to be underutilized.
A good comparison is the what happened to business travel due to the pandemic. All of the industries surrounding business travel from restaurants, hotels, conference centers, airlines, etc… are impacted due to the loss in movement of people. The commercial real estate industry will incur similar ancillary impacts with the elimination of the 1031 exchange as transaction volumes drop substantially.
Residential fix and flip basically eliminated
Think of the fix and flip business. If now all profits are taxed at 45%, there is no way the numbers work to buy a house and flip it. Currently someone could buy a house, fix it, sell it and exchange into the next property saving substantially on taxes until they finally “cash out”. Under the new proposal, the tax burden will eliminate the fix and flip business as it will no longer be profitable to make money.
Regardless of your political affiliation or philosophy on taxes, it is undisputed that there is no free lunch. If the 1031 exchange and long-term capital gains are eliminated there will be costs to the economy.
Many times, the costs of taxes far outweigh the benefit. For example on the 1031 exchange, the professors discovered that that the estimated taxes paid in an exchange which is followed by a taxable sale are on average 19 percent higher than when an ordinary sale is followed by an ordinary sale. Essentially the exchange actually generates more revenue for the government over the long term.
When Biden rolled out this plan, like many politicians, he touted the huge benefits to the government balance sheet. Unfortunately, money doesn’t grow on trees and neither do jobs. There will no doubt be a considerable loss in high paying jobs at banks, title companies, real estate firms, etc.. that will drastically reduce headcount. Furthermore the fix and flip business will be all but eliminated due to the new tax burden.
I always find it amusing that most politicians do not understand basic economics. In simplest terms the “economy” is like a bathtub when you pull the water on one side it eventually returns to center regardless of what happens. In the case of the increase in taxes on real estate, there will be offsets in other places in the economy. As taxes on real estate transactions increase, values will decrease, the irony is that a large portion of commercial real estate is held by pension funds. As their real estate values decrease, they will either pay less in benefits (which rarely happens) or increase taxes further to compensate for the loss in value of their portfolio. Politicians from both parties, please remember there is no free lunch or golden ticket.
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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