It is unlikely that 1031 exchanges will be a serious funding source for “the caring economy” plan.
Democratic presidential candidate Joe Biden on Tuesday unveiled a 10-year, $775-billion plan to support what he deemed “the caring economy,” which is comprised of jobs that provide care for children and the elderly. In order to finance this proposal, Biden is looking to the real estate investment community.
Like most proposals announced on the campaign trail, this plan has garnered a lot of headlines while offering few details; meanwhile, American voters are left trying to fill in the blanks, leading to assumptions about the plan’s intentions.
Here’s what we do know:
- Like-kind exchanges, commonly called 1031 exchanges, are specifically being targeted
- Real estate investors with incomes of more than $400,000 will be a focus
Under section 1031 of the Internal Revenue Code, 1031 exchanges are tax-motivated transactions that allow investors to sell real estate holdings for a profit and avoid paying taxes on gains, as long as those proceeds are invested into another “like-kind” of real estate asset. This tax provision is often used by high-net-worth investors and family offices as a tax mitigation and planning strategy. The survival of 1031 exchanges was assured under the Tax Reform and Jobs Act.
It is unlikely that 1031 exchanges will be a serious funding source for “the caring economy” plan. According to Congress’s Joint Committee on Taxation, the use of 1031 exchanges is projected to result in only $51 billion in tax savings from 2019-2023. Even if that number were to triple over a 10-year period, the proposed plan would still fall $625 billion short in funding.
Furthermore, when we focus on the middle market real estate investment community, the use of 1031 exchanges is primarily a tax strategy for a niche market of smaller investors; more than 60% of 1031 exchanges involve properties worth less than $1 million, according to 1031taxreform.com.
High earners and long-term capital gains
Shifting our focus to the funding that could be provided by real estate investors with incomes more than $400,000, we start to get a clearer picture of how the $775 billion plan will be financed. In order to dive below the headlines of recent days, we need to look at Biden’s overall tax proposal announced earlier this year.
The Biden campaign previously outlined tax reforms that would target all individuals, not just real estate professionals, who make more than $400,000 annually with the following:
- Providing 12.4% old-age, survivors and disability insurance
- Reverting the top end tax rate back to 39.6% from 37%
- Taxing long-term gains and qualified dividends at the ordinary tax rate, not a flat 20%
- Limiting itemized deductions for high-earning individuals
- Phasing out qualified business income deductions (section 199A)
These changes, in particular increased taxes of long-term capital gains, will have a substantial impact on the real estate investment community. While large, tax-exempt real estate investors such as pension funds will shrug at this change, for-profit real estate investors have come to rely on this tax benefit to produce yields that have inflated real estate values, helping to drive profits for all real estate investors.
The long-term capital gains tax policies will have broad implications, with traditional equities investors also seeing a rise in their taxes. Steeper taxes on high-earning individuals, including this capital gains tax, are estimated to raise $1.2 trillion over 10 years, according to taxfoundation.org, and would be able to foot the estimated $775 billion bill that comes with the “caring economy” plan.
In summary, the tax plan outlined by the Biden campaign in April will have a significant impact on real estate and non-real estate investors. Changes to the 1031 exchange rules will impact smaller investors, but not the broader institutional investment community. However, the changes in capital gains rules will reduce after-tax returns for a broad array of real estate investors, which would translate to a decrease in valuations of long-term hold assets such as real estate.
The combined impact of these changes would likely reduce property turnover, which is a driver for renovations and economic growth through the creation of construction jobs and the consumption of building materials. When owners are not incentivized to sell, real estate become stale and a driver of community reinvestment is taken off the table.