President Joe Biden signed nearly three dozen executive orders in the first six days of his administration. Most of them involve rolling back policies enacted under his predecessor or dealing with the ongoing Covid-19 pandemic.
Many more executive orders are likely to come in Biden’s first 100 days in office as all signs point to an aggressive and ambitious start to the 46th U.S. President’s term.
Fortunately for real estate investors, Biden’s attention is so focused on continued policy reversals, reinstatements, revocations, and managing the coronavirus that it seems unlikely his executive pen will swing toward 1031 exchanges anytime soon.
Rolling back tax-advantaged 1031 exchanges
In mid 2020, President Biden floated a proposed tax plan that would eliminate tax-favored Section 1031 exchanges for certain real estate investors. Buried deep within the “Biden Plan for Mobilizing American Talent and Heart to Create a 21st Century Caregiving and Education Workforce,” is a line that struck at the heart of the real estate investment community. Biden’s far-reaching plan, expected to cost $775 billion over the next decade, would be funded by rolling back tax breaks for real estate investors making more than $400,000 per year.
Although it appears squashing 1031 exchanges are in the new President’s crosshairs, it's unlikely to happen this year. Early indicators are that Biden’s attention is more focused on economic stabilization, eliminating the threat of the pandemic through vaccination, and addressing immigration and racial/ethnic inequities than canceling or modifying Section 1031 of the Internal Revenue Code.
And that’s good news for both the investment community and the greater American economy.
Wide-Ranging Economic Impact of 1031 Exchanges
Investors have used 1031 exchanges for decades to manage potential tax liabilities on the sale of real property. Investors can defer 100 percent of capital gains and depreciation recapture taxes by reinvesting any sale proceeds into “like-kind” properties of equal value or asset class.
These tax-deferred exchanges account for a significant portion of commercial real estate transactions. A 2020 1031 exchange economic impact survey by researchers from the University of Florida at Gainesville and Syracuse University in New York estimated that between 10 and 20 percent of all commercial real estate transactions from 2010 through 2020 involved like-kind exchanges. Furthermore, the research services team at Marcus & Millichap reported that almost one-quarter of the firm’s business from 2017 through 2019 involved buyers completing 1031 exchanges. Lastly, the median sales prices of exchange properties for 2018 and 2019 was $500,000, indicating that a significant portion of exchanges are completed by retail investors rather than large institutional buyers.
There’s a longstanding misconception about 1031 exchanges that likely put them on President Biden’s radar: They are used by wealthy individuals to shelter income from capital gains taxes. To that end, it’s important to note that taxes are only deferred and not eliminated. Investors who complete 1031 exchanges and then sell their assets without completing another exchange are liable for all taxes incurred during any previous sales.
These tax-deferred exchanges give everyday investors increased options when reallocating assets or rebalancing their portfolios. They create increased liquidity and transaction volume in commercial real estate markets, as well as contribute taxes at the local, state, and federal levels -- and two-thirds of all 1031 exchanges are later sold in standard taxable transactions, the study reported.
Perhaps the biggest financial benefits from 1031 exchanges are their ability to stimulate investments in real property and the countless jobs those investments support for title companies, appraisers, exchange facilitators, and others. Eliminating or repealing Section 1031 of the Internal Revenue Code could depress real estate prices, stifle transaction volume, increase rents, and trigger increased use of leverage to purchase commercial assets.
Without the ability to exchange properties, investors are likely to hold assets much longer, which could lead to a slowdown in adaptive reuse that has revitalized countless downtown and urban cores in cities across America. The Biden administration is razor-focused on revitalizing the national economy. It seems prudent, therefore, to leave in place a key economic tool that provides a host of benefits to so many aspects of the economy.