Changes in federal, state, or local regulations by governing bodies can negatively impact many sectors of business, financial securities, or the stock market. These changes could lead to higher costs of doing business, unfavorable tax environments, or even unhinge an industry’s entire business model.
These unforeseen and largely uncontrollable changes enacted by key regulatory bodies also can heighten the risk of doing business or investing in certain assets. Two examples of regulatory risk in real estate are President Biden’s proposed changes to 1031 exchange tax laws and raising the highest capital gains tax rate from 20 percent to just under 40 percent. These proposed changes would greatly affect a wide swath of real estate investors and their assets, and the proposals have already led to increased regulatory risk since the playing field for 1031 exchanges and the future of capital gains taxes remain in question.¹
Regulatory risk can take on many different forms. Tech’s Big Five (Apple, Amazon, Microsoft, Facebook, and Alphabet/Google) all have faced some form of regulatory risk, from privacy concerns to federal antitrust lawsuits. These pressures have likely led to many heated round-table discussions among top company executives, but Big Tech has largely shrugged off the additional regulatory risk as evidenced by recent share prices and company valuations – four of the five belong to the elite trillion-dollar-plus valuation club.²
Regulatory risk can lead to changes in the way an entire industry does business. In March of 2022, the Food and Drug Administration was allowed to regulate e-cigarettes that contain synthetic nicotine, a large shift in policy that’s likely to be a gut-punch to both large and small manufacturers of vaping products who had been side-stepping FDA oversight by using lab-made nicotine.³
These varied examples highlight a key aspect of regulatory risk: It can crop up almost anywhere. Sometimes regulatory risk materializes from perceived or real harm to the public, like the formerly unregulated e-cig industry, or the Cambridge Analytical data privacy scandal that rocked Facebook back in 2018. Other times it can crop up due to a perceived “gaming the system,” such as the notion that Section 1031 exchanges are a loophole wealthy investors use to expand their real estate holdings without paying taxes.⁴ However, research shows that the median sale price for properties involved in 1031 exchanges in 2018 and 2019 was $500,000, proving that Main Street, not Wall Street, are the primary taxpayers taking advantage of 1031 exchange tax-deferral strategies.⁵
Other examples of regulatory risk include new fuel-efficiency standards for American-made automobiles, or heightened scrutiny of the pharmaceutical industry in the wake of the opioid epidemic.
How to Mitigate Regulatory Risk
Many of the above examples have led to strategic planning, heightened compliance, and increased identification of current and potential risk factors in an attempt to manage regulatory risk. Large companies employ risk mitigation professionals and use complex regulatory compliance software to gather information, perform due diligence, and assess their risk profile in an attempt to manage regulatory risk.
It’s a bit different for solo investors. Managing regulatory risk requires a full understanding of a regulatory entity and its ability to change or impact the current business environment. Identifying potential regulatory risk factors, such as the proposed changes to 1031 exchange laws, can help investors navigate both current and future investment decisions.
The Bottom Line
Risk management is a dynamic and changing process. Regulatory risk often leads to dark skies without actually producing rain. In these instances, managing regulatory risk requires strategic planning and a long-term strategy that accounts for both current regulations and proposed regulatory changes. This strategy can help individual investors position their capital in ways that account for potential shifts in policy that could impact their investments.
Sources:
1. Revenue Effects of President Biden’s Capital Gains Tax Increase, Wharton School of the University of Pennsylvania, https://budgetmodel.wharton.upenn.edu/issues/2021/4/23/revenue-effects-of-president-bidens-capital-gains-tax-increase
2. Factbox: Tech Giants Dominate Wall Street’s Trillion-Dollar Club, Reuters, https://www.reuters.com/markets/europe/tech-giants-dominate-wall-streets-trillion-dollar-club-2021-12-09/
3. A Small Policy Change Could Transform the U.S. Vaping Industry, Time, https://time.com/6156327/fda-synthetic-nicotine-regulation/
4. Investors Fret as Biden Takes Aim at a 100-Year-Old Tax Loophole, New York Times, https://www.nytimes.com/2021/06/08/business/like-kind-real-estate-tax-loophole.html
5. The Tax and Economic Impacts of Section 1031 Like-Kind Exchanges in Real Estate, The Real Estate Research Consortium, https://www.ipa.com/wp-content/uploads/2021/03/Ling-Petrova_Like-Kind-Exchanges_RELKEC_10-05-20.pdf
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