During my time working with and for real estate investors, I heard about the 1031 exchange often. Typically, the sale of a rental property would generate tax consequences in the form of capital gain, a tax event that could be significant for the seller of the property. However, the seller reinvests that money into another rental property, using a 1031 exchange, a tax incentive in named after Section 1031 of the United States Internal Revenue Code the tax consequence can be avoided.
The new property has to be similar, the same or greater value, and the proceeds from the sale has to go immediately into escrow, and new property purchased in six months. First created in 1921, 1031 was originally was a direct exchange with another party until a court decision in 1979 allowed sale and reinvestment. According to a report by the Joint Committee on Taxation, "Estimates of Federal Tax Expenditures for Fiscal Years 2019-2023," the exchange cost the federal government about $50 billion in uncollected taxes between 2019 and 2023.
The use of the incentive has been key for many small business owners who were buying a property as a rental, from a single-family home to an apartment building, to essentially trade up without getting hit with a potentially profit killing tax consequence. An investor could buy a building for $100,000, manage it well, then sell it for $200,000 and apply that cash to a larger property selling for $300,000. The practice could when used effectively contribute to the expansion of real estate portfolio of rental housing. Critical to the success of this strategy is effective management of the asset and timing the moves well to be sure the transaction is complete and the new property has decent cash flow.
Now, the Biden administration has proposed a limit on 1031 exchanges to $500,000 per tax payer. For a new investor, moving from one single-family rental property to another one, this limit might not have an effect. But for investors buying apartment buildings of even modest size, the limit would be prohibitive. It’s likely that the limit could end the use of the 1031 exchange for wealth building and investment in rental properties at scale. Arguably, this could impact housing supply by reducing investment and improvement of existing housing supply. Housing doesn’t build and operate itself; there has to be some capital to make it work. Eliminating the 1031 exchange would incentivize different behavior, less supply, and higher prices which would hurt consumers with fewer dollars and people hoping to build wealth.
Brent Abrahm is President and Chief Executive Officer and Co-Founder of Accruit, a company that facilitates 1031 exchanges. Companies like Accruit are important to guide investors through the complicated tax code issues that can arise during a transaction and after. Abrahm has been an advocate for the 1031 exchange and responded to a series of my questions about it and possible changes.
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Isn't this just a tax dodge used by wealthy landlords and house flippers looking to avoid paying taxes on their ill-gotten gains?
Quite the opposite, most replacement properties acquired in a 1031 Exchange are disposed of through fully taxable sales, not subsequent exchanges. And typically, at that time of the sale the gains are even higher due to appreciation of the investment.
The U.S. Tax Code is very specific regarding how an investor accounts for a 1031 Like-kind exchange. The investor is limited by the amount of an annual write-down, in the way of depreciation expense, on the replacement property if depreciation was previously taken on the sold asset. This is simply a timing difference. Allowing owners of property to reinvest 100% of the proceeds into “like” property versus incurring more debt to offset the money used to pay taxes, resembles an interest-free loan from the government supporting the two primary purposes of the legislation.
“House flippers” are not eligible to utilize 1031 Exchanges, which require that the property be held for investment or business purposes, with a general guideline of holding the property for a minimum of two years. Homes being “flipped” are considered inventory, not held for investment.
What's a simple explanation of the Biden proposals and why have they been proposed?
The Biden proposal caps deferrable gains on a 1031 Exchange transaction to $500,000 per individual annually or $1,000,000 for couples filing jointly. Effectively a repeal of the code section.
Why the proposal?
1031 Exchanges are being looked at as a “pay-for” (i.e., a revenue generator for the U.S. Treasury) supporting other tax initiatives proposed by Biden. However, when you actually look at the numbers comparing repeal to the economic activity derived by retaining 1031 Exchanges in their current state, the math is obvious and in favor of retaining this 103-year-old regulation.
For this reason, many Democrats do not support the President’s repeal. Research by Ernst and Young reported that in 2021 economic activity generated by 1031 Exchanges supported 976,000 jobs generating over $48 billion of labor income and contributing over $97 billion to the US GDP. According to Ernst and Young, this economic activity generated $13 billion in federal, state, and local tax revenue. They also found that 1031 Exchanges produce an additional $6 billion in federal tax revenue due to foregone depreciation (reduced deductions) on the replacement property. Since 1031 Exchanges generate significantly more revenue than would result from capping the provision, any cap or change to section 1031 would be detrimental to both the public and private sectors of the U.S. economy.
Are there improvements that could be made to 1031 Exchanges?
Today, 1031 Exchanges are narrowly defined. Prior to the Tax Cuts and Jobs Act in 2017, taxpayers could utilize 1031 Exchanges in connection with the sale of assets beyond real property. My industry colleagues and I would prefer to see them retained as they are currently codified with no future changes or “improvements,” allowing 1031 Exchanges to continue to have the economic impact we have seen for over 100 years.
Do you have any general comments about attitudes toward real estate investment that are unhelpful and contribute to bad tax policy?
There has been discussion in Washington by aggressive tax opponents that real estate investments would benefit by “immediate expensing” similar to tax policies for short-term assets (business and construction equipment, cars, etc.). This type of policy would encourage excessive building regardless of demand as well as encourage over leveraging debt to avoid paying taxes. For example, this idea would allow the construction of a $100 million office complex to benefit the investor by having an immediate write-off of $100 million, while realizing the economy doesn’t need more office space at this time. On the other hand, 1031 Like-kind exchanges support economic growth ensuring the best use of capital is deployed effectively in the places that provide a return on such investment.
