President Joe Biden's American Families Plan contains a provision sharply cutting back, but not eliminating, the 1031 exchange tax break that originated ironically enough exactly 100 years ago.
A 1031 exchange -- also recognized by the IRS as a like-kind exchange-- enables real estate investors to defer the capital gains tax liability on the sale of an investment property by using those proceeds to buy another property.
Biden's plan would limit the capital gains break on a like-kind exchange tax shelter to transactions under $500,000, the latest in major changes to what originated as Section 1031 of the Internal Revenue Code in 1921.
Arguments for and against limiting the like-kind exchange break are laid out in this Bloomberg article, which says that this year, the tax break will save individuals about $5.7 billion and corporations about $2.3 billion, according to Congress’s Joint Committee on Taxation.
For some additional perspective on the proposed limits, we turned to Charles Clinton, CEO of investing platform EquityMultiple, and Paul Getty, CEO of First Guardian Group, an investment firm that includes a specialty in 1031 work, for answers to a few questions about the proposed new limits.
How much impact do you think this restriction on 1031 exchanges would have on real estate investing?
Charles Clinton: It's hard to overstate how widely used 1031 exchanges are within the real estate investing market. Congress has put the pin at $41 billion in savings between 2020 and 2024 to give a rough idea, so it's safe to assume we could anticipate a degree of sea change in investor mentality and decision-making if this comes to fruition.
First, the analysis on whether to sell or hold a property will change significantly, at least for owners who previously would have utilized the 1031. The tax deferral benefit that once encouraged successful exit and reentry into new projects will leave a significant transaction slowdown in its wake, as more investors opt to stay in and refinance rather than realize gains and move into new projects (particularly with the potential hike in capital gains rates).
We should also expect to see some sectors impacted more than others -- NNN (triple net lease) retail sees heavy 1031 investment, as do other "buy-and-hold" properties like stabilized multifamily in core markets.
Investors are willing to accept lower yields in many cases because of the tax benefits of deferral, so without that benefit, they may demand higher yields on purchase and thus lower purchase prices. Put another way, this would put upward pressure on cap rates, at least in those subsectors where there is heavy 1031 investment.
Paul Getty: The impact would be especially significant on smaller investors and would reduce housing stock. Per IRS statistics, four out of five individual filers who claim long-term capital gains from real estate report adjusted gross income of $200,000 or less. Smaller investors who own single-family rentals, smaller retail, and offices are the largest beneficiaries of 1031 tax deferrals.
Further, 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.
How many deals fall under the $500,000 threshold as compared to over, in your experience and estimation?
Charles Clinton: A tiny fraction of deals fall under the $500,000 threshold, so this proposition if passed would effectively eliminate use of the 1031 exchange by professional real estate investors. Purchasing properties under that threshold will be challenging, especially in sectors that demand higher investment, like NNN retail.
An alternative 1031 eligible structure, Delaware Statutory Trusts (DSTs), has increased in popularity in recent years as a way of fractionalizing larger investments so that they are 1031-eligible for smaller investors. We have generally utilized this structure when offering 1031-eligible investments because our investors typically invest $20,000 to $500,000 per investment. With the new $500,000 threshold, DST investments would dominate the remaining 1031 market.
Paul Getty: Our firm, First Guardian Group, manages properties and investments for mom-and-pop-type investors. Approximately 70% of our clients' transactions result in gains of less than $500,000.
What would you expect the impact to be on opportunity zone investment, and why?
Charles Clinton: This change would drive significant new demand for investments in opportunity zones (OZs). If the largest avenue of tax deferral goes away, the remaining option stands to benefit. There are key differences in 1031 and OZ investment requirements, so demand will not be one-for-one. Opportunity zone investments involve new construction or heavy renovation, while 1031 favors stabilized properties, and opportunity zones require a 10-plus-year investment horizon, while 1031s do not have a similar restriction.
Paul Getty: We're already experiencing heightened interest in QOF (qualified opportunity fund) investments as an alternative to 1031 exchanges. Presuming that opportunity zones are not negatively impacted, we would expect significant increased demand.
What do you recommend real estate investors above that threshold and under that threshold do now?
Charles Clinton: For real estate investors under that threshold, sit tight; there will still be options. There is a huge apparatus within CRE (the commercial real estate industry) to provide 1031 exchange-eligible investments, and if the pool of eligible capital shrinks, investors with under $500,000 may benefit in terms of improved options in the short term. Over that threshold, it really depends on goals and financial planning. If you're already contemplating a sale, think about accelerating that or, at a minimum, get smart on opportunity zone investing as a potential alternative.
Paul Getty: Our clients have taken advantage of other tax deferral programs such as 721 exchanges into an UPREIT, various types of installment sales, and charitable donations, among others. Investors can be expected to lever up the loans on their properties, since funds obtained from financing properties are not taxed.
Many investors, however, will simply not sell, which will exacerbate the current housing shortage in the U.S. and lead to higher rents. Landlords are mostly conservative and will become more active in electing officials that support tax incentives for real estate investments.
How likely do you believe the changes are likely to come to pass?
Charles Clinton: This one is admittedly over my political knowledge paygrade, but we can be sure it will be met with massive resistance and lobbying. This is a deeply entrenched part of the CRE industry that is utilized by a huge range of investors -- from retail investors up to the largest institutions.
Paul Getty: Reconciliation (passage of new laws with only 50% approval in the Senate) worries many of our investors, who fear they'll wake one morning and discover they've lost many of their real estate tax benefits without much debate in congress. Powerful real estate lobbies are now at work targeting politicians with large concentrations of real estate investors and industry professionals in their districts.
Studies show that only about $40 billion in tax revenues could be raised by eliminating the 1031 (best case) -- and the resulting loss of real estate-related jobs and housing stock may not motivate enough politicians to eliminate or further compromise the 1031 exchange -- or so we hope.
The Millionacres bottom line
Getty says the "unprecedented high volume" of 1031 exchange transactions he's currently seeing indicates a lot of investors think now's the time to sell to get ahead of changes in 1031 exchange rules or any other capital gains breaks.
If you think you might be one of those investors, too, consult your investment advisors and real estate professionals to help inform your thinking before making some possibly very consequential decisions.