Q: Joan asked, we own several rental homes and commercial properties. I understand that Joe Biden has proposed the elimination of the 1031 exchange process. What could be the potential impact on our wealth and tenants if Joe Biden becomes President and eliminates 1031 exchanges?
A: Joan this is a common consider by many owners of such investments around the US. 1031 exchanges (also called “Starker” or “like-kind” exchanges) allow real estate investors to defer tax payments after they sell real estate — provided that the investor subsequently reinvests in another property. This is an enormous benefit to real estate investors, obviously. But the benefits go much further. The entire real estate sector benefits from such exchanges, especially:
- Brokers and agents (more deals)
- Banks and mortgage lenders (more borrowers)
- Other property owners (more demand for real estate)
- Tenants (more and more affordable housing options)
- Cities and localities (higher property taxes, more investment)
Do not just take my word for it. In 2015, Professors David C. Ling and Milena Petrova (Universities of Florida and Syracuse, respectively) published The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate. Their 93-page report found:
- In the longer run, rents would need to increase from eight to 13 percent to offset the effects of elimination.
- That would shrink the supply of available rental space for businesses and individuals.
- Price and rent effects would be more pronounced in high-tax states.
- “High-tax states” include, among others, California, New York, New Jersey, Hawaii, Oregon, and Minnesota.
This study also dispelled the myth that 1031 exchanges are an end-around used by the rich to never pay taxes. In contrast with the common view that replacement properties in an exchange are frequently disposed of in a subsequent exchange to potentially avoid capital gain and depreciation tax liability indefinitely, we find that in 88 percent of those cases in our dataset investors dispose of properties acquired in a 1031 exchange through a taxable sale. And even more critically, the taxes paid are often higher than they otherwise would have been. The estimated taxes paid when an exchange is followed by a taxable sale are on average 19 percent higher than taxes paid when an ordinary sale is followed by an ordinary sale.
Ling and Petrova published a follow-up study in 2020. That study concluded that the elimination of the real estate exchanges would likely lead to a decrease in commercial real estate transactions, as well as, price declines in some markets.
In essence, the suggestion to eliminate 1031 exchanges won’t raise more revenue in the end. It’ll just trade lots of future tax revenue for less current tax revenue. And it’ll put a huge dent in the real estate sector. Ling and Petrova summed it up best:
“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, an increase in investment holding periods, and an increase in the use of leverage.”
The Biden 1031 Plan Traffics in Several Myths
In my opinion, going after real estate investors is probably good politics. It’s just lousy economics.
That said, it is easy to see the attraction of targeting “like-kind” exchanges.
- only going to offend a relatively small voter base
- get to call plays from the Robin Hood economics playbook
- real estate transactions generate large tax bills
- benefits to landlords and developers aren’t popular; programs for the young and elderly are.
In fact: It’s a long-standing trope to say that “1031 exchanges favor the rich” at the expense of the working and renting masses.
This is an understandable conclusion if you’ve never interacted with 1031 exchanges or the relevant data.
As we’ve already discussed, the vast majority of 1031 exchangers follow up their exchange with a taxable sale. As we’ve seen that those sales bring in more tax revenue than otherwise would have generated. We could go on.
Other common trafficked 1031 myths:
* 1031 exchanges are a net drag on the economy * 1031 exchanges favor real estate developers * We don’t need 1031s anymore because of Opportunity Zones
Some of these are debatable. Others are completely wrong. Personally, I believe 1031 exchanges are important to overall wealth transfer planning for all Americans and need to remain an integral part of the US tax code.