President Biden’s tax agenda includes several changes that may affect real estate investors. One of the more high-impact changes is the potential elimination of the 1031 exchange which many real estate investors take advantage of every year. Real estate tax law changes are expected to include:
- Eliminating or modification of the 1031 exchange
- Possible increasing the long-term capital gains tax
- Eliminating or changing the estate step-up in basis
There may also be changes to the corporate tax rate and the Qualified Business Income Deduction. In this article, we’ll explore how these changes may impact investors.
Democrats in Control
With the January 5 Georgia Senate races going to the Democrats, they now effectively control the Senate since the Vice President (also a Democrat) can break any tie. The Democrats also hold a majority in the House of Representatives, giving them full control of Congress. This majority control means that President Biden has a better chance of pushing through new legislation.
1031 Exchange Overview
A 1031 exchange is only applicable for real estate, not stocks. It works like this: an investor owns a piece of real estate that goes up in value. There’s a tax rule that allows the investor to sell the first property and buy another like-kind property.
The investor can defer all gains on the first property, moving them over to the new property. The investor can then continue earning income from the new property while taking advantage of tax deferral on the first property.
If the investor passes away, their asset is stepped up in basis for their beneficiaries. If those beneficiaries decide to sell the property at the stepped-up basis price, they won't have to pay any capital gains taxes.
Impact on Real Estate Investors
There are four main components of Biden’s tax plan to unpack that may affect investors:
Potential Elimination or Modification Of 1031 Exchange. If the new tax proposal eliminates the 1031 exchange, investors may lose the ability to fully defer taxes at the time of sale. It is unclear at this junction if a full or partial deferral is under consideration.
Capping the Amount of Capital Gains Tax Investors Can Defer to $500,000. This would mean investors can only defer the first $500,000 of capital gains tax they would see at the sale of their property. Any taxable capital gains above the $500,000 level would be taxed at potentially the newly proposed capital gains rate (which we speculate will be around 40%; exact amounts are fluctuating).
Increase In Long-Term Capital Gains Tax. Additionally, there is a proposal to increase long-term capital gains tax rates. Those earning over $1 million may pay 39.6% instead of 20% top rate in capital gains taxes. At that rate, capital gains are taxed at ordinary income tax rates.
Elimination Of Step-Up In Basis. Also up for review is to eliminate the step-up in basis at death tax benefit. The step-up in basis allows an investor to pass property to their heirs at the fair market value (at the time of death) rather than at the original purchase price.
Currently, taxpayers receive step-up in basis at death of up to $11.5M for individuals and $23M for married couples. The Biden plan proposes reducing the limitation to gains in excess of $1 million per individual or $2.0 million per couple ($2.5 million including the $500k primary home exclusion).
It's important to note that these limitations change from time to time and have been increased and decreased many times over the years.
As an example of the step-up in basis, if the original purchase price of a property was $500,000 and now it is worth $800,000, the basis to heirs will be $800,000. The heirs will not owe any taxes if the property is sold for that price. The elimination of the step-up means the heirs may owe capital gains taxes on $300,000.
Broader Impact of Eliminating the 1031 Exchange
In addition to the 1031 exchange's eliminations impact on individual investors, there's a trickle-down effect that comes into play. A 2015 study by the National Association of Realtors found that 63% of realtors participated in a like-kind exchange (i.e., 1031 exchange).
That’s a significant amount of business just from 1031 exchanges, considering all of the businesses that participate in 1031 exchange transactions:
- Appraisers
- Attorneys
- Banks
- Title companies
- Realtors
Additionally, investors purchasing new property often need to make improvements. Those improvements bring in contractors and the purchase of materials from the local economy.
There have been several economic studies showing the effects of a Section 1031 repeal, particularly Ernst and Young and Ling-Petrova. The studies found that a repeal of IRC Section 1031:
- Results in less federal revenue
- Shrinks the U.S. economy up to $13.1 billion annually
- Discourages investment
- Negatively impacts the economy
- Unfairly burdens certain businesses and taxpayers with an unfair concentration in other industries
- Is at cross-purposes with the goals of tax reform
1031 exchanges provide great tax benefits to real estate investors. Those earning over $1 million may be hit especially hard by the new tax law changes. Not only do they lose the ability to make like-kind exchanges, but they'll also have the potential to be taxed at 39.6% on capital gains. Many heirs may be affected as well by the loss of the step-up in basis associated with the death estate inheritance rule.
What Actions Can Investors Take?
The silver lining to all of this is that there is still time to make your voice heard when it comes to potential changes to the tax code. There's speculation to the House Ways and Means Committee will discuss including these changes in their upcoming session, which begins in mid-May. If you want to voice an opposition to changing the existing tax code, tell your Representative you want them to save the 1031 Exchange. You can visit this page to determine who the appropriate Congressman is in your area and tell them you want to save the 1031 Exchange.
This material represents an assessment of the economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
