The 1031 Exchange is a 100 year old tax provision favored by real estate investors. With the 2020 presidential candidates talking about it, what should be done?
In the past, both Republican and Democrat administrations have suggested limiting the extent of 1031 exchanges to raise funds for their proposed programs.
Previous attempts have not led anywhere because policymakers realized that they would be eliminating a tax provision that stimulates economic growth. This year the 1031 exchange reform has become a campaign topic once again.
The 1031 became a part of the Internal Revenue Code in 1921. There were solid reasons why this concept was embedded into the Tax Code almost 100 years ago and these same considerations remain true today.
What is a 1031 Exchange?
A 1031 Exchange, named for Section 1031 of the IRS tax code, is a tax provision that allows an investor to sell one investment property and buy another, while deferring capital gains tax. In other words, the investor can trade one property for another and, if the properties meet federal requirements, not pay capital gains at the time of the exchange.
Tax due on any capital gains from the sale of the first property is deferred until the investor decides to cash out and realize any capital gains. There is no limit to how many times an investor can execute a 1031 Exchange.
The concept is that a property investor who continues to increase investments will only have to pay capital gains tax one time. He can continue to invest and swap one investment property for a larger one until the moment he decides to cash out.
1031 exchange Myths Debunked
The 1031 Exchange is the subject of much confusion and misconception. Here are three common myths about the 1031 Exchange.
Myth #1: 1031 Exchanges allow taxpayers to avoid taxes forever
Section 1031 provides a mechanism to defer tax liability, not evade it. The deferral is temporary. In fact, over of properties acquired through like-kind exchanges are later sold through a fully taxable event.
When the sale takes place, the tax bill applies to the more expensive replacement property because the 1031 rules require the new property to be of greater or equal value than the original property.
Myth #2: 1031 Exchanges impact the wealthy
The 1031 Exchange is an incentive used by real estate investors big and small, including individuals, partnerships, limited liability companies, and corporations.
An industry survey showed that of exchanges involve properties worth less than $1 million, and more than a third are worth less than $500,000. Those that were worth more than $500,000 were family businesses, farms, and other properties where value represented multi-generational savings and life-long efforts to save up a nest egg that can improve quality of life.
Myth #3: Eliminating 1031 Exchanges will generate tax revenue similar to stocks
Only direct owners and business purpose investors can use 1031 exchanges, which are illiquid by nature. Stocks are investments in someone else’s business and are liquid.
While taxing the gain on the sale of a stock won’t hurt the business because it does not impact the cash flow or operations of the business, taxing the direct owner of a productive asset reduces the cash flow available for reinvestment into another productive asset.
Taxpayers doing a 1031 exchange are not taking any profit from the transaction. Instead, proceeds from the sale of the relinquished assets have to be reinvested. Taxing the gain discourages further investment because investors aren’t able to trade up.
1031 Exchanges stimulate economic growth
Section 1031 exchanges provide enormous benefit to real estate investors. But the benefits go far beyond that.
The value provided by 1031 Exchanges also extend to brokers and agents by supplying them with more deals. This means banks and mortgage lenders get more borrowers, increasing overall real estate activity.
The net effect is increased demand for real estate as an investment vehicle, which benefits other property owners by raising property values and gives tenants more housing options.
For these reasons, Section 1031 exchanges are even more important in the tough economic times created by the coronavirus pandemic. Repealing or limiting 1031 exchanges potentially hinders the effort of pulling the economy out of the current economic downturn.
A 90-page study from University of Florida on the Economic Impact of 1031 Exchanges on Real Estate outlines overwhelming evidence that these exchanges provide an important driver for the economy.
Specifically, the ability to defer capital gains by reinvesting in business use or investment properties stimulates business growth.
The impact of repealing 1031 Exchanges
The temptation by government to limit Section 1031 exchanges is motivated by desire to collect the funds sooner to sponsor other favored policies. But many people and tax-paying entities benefit when real estate frequently changes hands.
A macroeconomic study by Ernst & Young finds that repeal of 1031 would lead to increased cost of capital, reduced levels of investments, slower economic growth, and the long-term contraction in the overall U.S. GDP by approximately $8.1 billion annually.
This study highlights an important point. Section 1031 promotes reinvesting money domestically, as only U.S. properties qualify for an exchange.
Presidential candidate Joe Biden stated that he plans to raise cash for childcare and elderly services by limiting the tax deferral opportunity of 1031 exchanges to taxpayers with annual incomes of less than $400,000 per year. Over the history of this tax provision, several prior administrations proposed similar ideas.
But after careful consideration, previous administrations of both political parties avoided going through with limiting 1031 exchanges. Perhaps they concluded that this provision is an investment tool that benefits not just real estate players, but also many vulnerable demographics. For example, denying 1031 Exchanges to owners of assisted living facilities and preschools could have unintended consequences. These organizations use 1031 exchanges to upgrade facilities that better serve the children and seniors in their care.