With the change of administrations earlier this year, real estate investors and landlords have been put on high alert for policy changes that could impact their assets. Up on the chopping block once again is the 1031 exchange, a valuable part of the U.S. tax code for the last century. Please consider taking steps to contact your politicians as outlined at the close of this article.
History
Shortly after the adoption of the first U.S. income tax in 1918, Congress deemed it unfair to tax businesses and individuals who sell properties and reinvest the proceeds rather than spend them. The prevailing view, which has persisted over the past century, was that if a taxpayer receives nothing in the transaction to pay taxes on (funds are transferred to the new property rather than spent), no tax should be owed.
1031 exchanges have undergone many changes over the last 100 years, including attempts by politicians on both sides of the aisle to not only weaken investor benefits but also seek their outright appeal.
Most recently, the Tax Cuts and Jobs Act of 2017 resulted in the elimination of the 1031 exchange for personal and business property, while very fortunately, preserving the 1031 exchange for business-related real estate, including rental properties.
Impact on Real Estate Investors
Per IRS statistics, the elimination of 1031 exchanges would disproportionately hurt smaller investors and everyday people and impact the ability for individuals to enjoy retirement*. Many are counting on their real estate dollars to buoy their retirement funds; anything less might push back their retirement date or put them on a strict, fixed budget. In fact, per data from the Joint Committee on Taxation, individuals and not corporations receive more than 70% of the benefits of deferring taxes through 1031 exchanges. Furthermore, IRS data confirms that four out of five individual tax filers reported Adjusted Gross Income of $200,000 or less.
Further, eliminating the 1031 exchange will have a serious impact on residential renters by reducing stock of apartment supply and creating rising rental rates due to a supply and demand imbalances, worsening housing affordability at a time when both renters and owners are struggling to make rent and mortgage payments due to lost income from the pandemic.
Apartment transactions account for nearly one-third of all 1031 exchanges. The loss of the 1031 exchange would greatly reduce incentives for developers to build more units due to loss of profitability and reduce real estate capital investment and development, which would be truly detrimental to communities at a time when the U.S. is desperately in need of economic expansion.
1031 exchanges not only boost the amount of total real estate investment, contributing to greater liquidity and lower rental rates, they also make it possible to borrow less. By deferring the tax liability, investors participating in a 1031 exchange can allocate sales proceeds toward the purchase price of a new property, making a larger down payment and taking out a smaller mortgage which in turn is benefiting the greater overall market stability and creating additional value for local communities.
The repeal of 1031 exchanges would also negatively impact property values and would be felt most acutely in cities and regions where tax-motivated buyers are most active. State and Federal governments could also face reduced revenues as there will be fewer sales transactions and less taxes would be collected. Take California for example – a state with capped property taxes would experience a reduction in property taxes since fewer investors will sell and keep their older, lower property taxes in place.
Resulting Tax Revenues are a Drop in the Bucket
A widely circulated study by Professors Ling and Petrova calculated that, under a best- case scenario, the government would only collect an additional $41 billion in tax revenues**. While not a small amount, it is a microscopic percentage of the proposed $6 trillion in new spending (.0833%).
What You Can Do Now
First Guardian Group is a proud member of the Institute for Portfolio Alternatives, an industry advocacy group that is in the forefront of lobbying in favor of preventing any further changes to the 1031 exchange. They have provided a very easy to use template that will send your comments opposing 1031 changes to representatives in your voting district.
Please go to their website and make your voice heard: https://www.ipa.com/action/.
Summary
As our spending mounts and deficits continue to rise, real estate investors should expect more efforts by politicians on both sides of the aisle to further compromise and eliminate what real estate investors have long enjoyed. The time for a savvy use of the 1031 exchange is now.
*IRS, Statistics of Income Division, Sales of Capital Assets Data, Tax Years 2007-2012 (most recently available information)
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