It appears that the politicians are, once again, threatening to impose limits on how investors can defer taxes under the 1031 exchange. Since the creation of the 1031 exchange in 1921, some politicians have taken the position that real estate investors have a “sweetheart” deal whereby they can reinvest up 100% of the proceeds from the sale of an investment property as long as they continue to invest in real estate. They take the position that the government is in effect providing an indefinite interest-free loan favoring real estate investors over those who invest in other types of assets whose gains are taxed at time of sale.
The US Department of Treasury recently released their analysis of the current administration’s FY 2025 Budget. Among many sweeping changes to the tax code, this budget contains hard limits to the amount of tax deferrals that would be eligible for 1031 tax treatment. Specifically, the proposed changes would allow 1031 tax deferrals on aggregate gains only up to a limit of $500,000 for individuals or $1,000,000 for married couples who file jointly. 1031 exchanges above these annual limits would be recognized in the year the sale is completed and would be subject to taxes.
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 people 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.
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 is very small in comparison to $1.7 trillion in new spending authority in the FY 25 budget.
Moves to limit the 1031 exchange are likely to have far reaching negative consequences on the real estate industry and for real estate investors. 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 savvy use of the 1031 exchange is now.
First Guardian Group will publish further updates including suggestions on how investors can influence politicians to block the proposed changes.
Please contact FGG10131 | First Guardian Group for more information. You can also schedule a call directly with Paul Getty here.
1 https://home.treasury.gov/system/files/131/General-Explanations-FY2025.pdf. See page 147.
2 IRS, Statistics of Income Division, Sales of Capital Assets Data, Tax Years 2007-2012 (most recently available information)