Will the 2020 Election Mean the End of 1031 Exchanges?

Presidential candidate Joe Biden portrays 1031 Exchanges as a tax loophole for the wealthy, even though 1031 Exchanges are clearly codified within our tax code and are available to all owners of investment real estate – regardless of the property size or individual’s income. His proposal eliminates the use of 1031 Exchanges for taxpayers with annual income in excess of $400,000. Limiting the use of 1031 Exchanges is not only bad policy but reveals a lack of understanding of the role real estate plays in our economy.

Real estate represents a major portion of the U.S. economy. According to Ibis World, a global industry research firm, commercial real estate employs nearly 3.3 million individuals within the United States and is the U.S.’s 7^th largest industry. Real estate is such a large U.S. industry, in part, because of the ability for capital to move efficiently between properties. 1031 Exchanges are a major driver of that efficiency. Utilizing a 1031 Exchange, capital can be reinvested from one property to the next without a significant reduction from taxes. The movement of capital creates economic opportunity for brokers/agents, consultants such as appraisers, lenders, bookkeepers, property managers, construction workers, insurance agents and many other hardworking individuals. Candidate Biden talks about the taxes that are deferred annually through 1031 Exchanges as if these dollars would then be available to spend on social programs, which they will not. The reality is the volume or “velocity” of real estate transactions would decline significantly and with that decline would come the loss of hundreds of thousands of jobs.

California’s implementation of Proposition 13 in 1978 is a perfect example of how this concept would play out. Proposition 13 stated that the assessed value of property for tax purposes could not increase more than 2% annually beyond the 1976 value, unless there was either a change of ownership or completion of new construction. The result? Individuals owning property with a fair market value that exceeded the assessed value for property taxes purposes refused to sell their property due to the increased taxes they would bear upon the purchase of new real estate. Many properties went underutilized and undeveloped because the tax structure made it unattractive to either sell or improve. The same series of events would play out if 1031 Exchanges were limited.

This is not the first time eliminating 1031 Exchanges has been discussed as a means to narrow the deficit between our Federal tax revenue and Federal spending, nor will it be the last. Fortunately, several respected economists have studied the impacts of the proposal and the results are far from favorable for Americans. A 2015 report co-produced by David Ling of the University of Florida and Milena Petrova of Syracuse University entitled “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate” states:

“[…] 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.”

In the same year, Ernst & Young produced a report quantifying the impact of eliminating 1031 Exchanges at a net reduction in GDP between $61 billion and $131 billion over a 10-year period. In 2016, the Tax Foundation produced a report stating that eliminating 1031 Exchanges would provide $4 billion of additional annual tax revenue at a cost of $18 billion in GDP – hardly a return on investment anyone would consider attractive.

In summary, 1031 Exchanges create jobs that benefit millions of Americans. Section 1031 is not a tax loophole, but a very intentional section of our tax code that benefits individuals of all economic levels. Do wealthy real estate investors benefit from 1031 Exchanges? Yes. Do “mom and pop” property owners benefit from 1031 Exchanges? Yes. Do tenants and small businesses benefit from 1031 Exchanges? Absolutely. Hopefully Candidate Biden will move beyond political rhetoric and take a good look at the economic data to support maintaining 1031 Exchanges. Failure to do so will negatively impact an industry already being asked to shoulder a significant portion of the turmoil that has resulted from Covid-19 and is quite simply bad economic policy, in my opinion.

If you are considering a 1031 Exchange and have questions, contact Real Estate Transition Solutions to schedule a complimentary consultation. Our free consultations can be done over the phone, via web meeting, or in person at our office in Seattle, Washington, or in Portland, Oregon. To schedule your free consultation, call 206-686-2211 or click on button below.