What Do Biden’s Tax Proposal Changes Mean for the 1031 Exchange?

On April 28th, 2021, President Biden revealed several tax proposals that could affect real estate investors. One of these proposals involves curtailing 1031 exchanges, a long-standing and regularly used strategy for deferring capital gains tax.

A 1031 exchange is one of the key tax benefits of investing in rental properties and allows investors to defer capital gains by essentially swapping one property for another one of a like-kind. This allows them to maintain their capital in their investments and is a key tool used by real estate investors to grow their respective businesses.

Under President Biden’s proposal – and it’s important to note that this is just a proposal at this stage – section 1031 would be modified to increase the tax liability of wealthier individuals by limiting the maximum amount of capital gains that can be deferred to $500,000. This proposal also suggests several other key tax changes which could dramatically change how investors structure and manage their portfolios. These additional changes include increasing the long-term capital gains tax and eliminating the step up at the point of inheritance of a property.

Bidens 1031 proposal is a part of his campaign promise to begin to reduce economic inequality and stimulate future economic growth. However, it has, not unexpectedly, caused some contention with many arguing that these changes could easily have negative consequences on the industry. In this article, we take a look at what a 1031 exchange is and the arguments for and against Biden’s 1031 proposal.

Key Takeaways

• Raise the top capital gains tax rate to 39.5% for households making over $1 million.
• Limit the ability to defer capital gains through 1031 exchanges where the gains are over $500,000.
• Remove the ability for the value of property to be “stepped up” when inherited (with a provision to protect family run farms).

What is a 1031 and how does it currently operate?

Broadly defined, a 1031 exchange is a swap of like-kind properties eg. one investment property for another. We explore in more detail what like-kind means further down the article. If you meet the requirements of 1031, you’ll either have no tax or limited tax due at the time of the exchange. Essentially, a 1031 allows you to change the form of your investment without cashing out and being subjected to capital gains taxes. In this way, you can defer capital gains on your property.

There are currently no limits to how many times or how frequently you can do a 1031 exchange instead you could roll over the exchange from one property to another, and then another. When you do eventually sell though you will have to pay capital gain tax which will be at the long-term capital gains rates (currently around 15 – 20%). However, if you hold onto the property until death, the person who inherits it can currently step up the value of the property effectively negating all capital gains and resetting the value of the property to its current market value.

The 1031 provision is for investment and business properties, however, the rules can apply to a primary residence under particular conditions and you can also use a 1031 exchange for swapping out a vacation home – again if you meet particular criteria.

What are the proposed changes that could affect real estate?

There are three major proposals that Biden made that could affect landlords. Firstly, Biden has proposed hiking the tax rate on capital gains for households making over $1 million.

The White House proposes raising the rate to 39.6% for millionaires, up from 20% where it currently stands for the country’s top earners. Additionally, the Biden administration has called for ending the ability to “step up” the cost basis for real-estate when it is inherited. The stepping up allows heirs to calculate capital gains on the sale of a home or other property using the market value at the time they inherited it, rather than when it was originally purchased.

‘Stepping up’ the basis can reduce the tax burden for heirs considerably in these circumstances. Finally, Biden is calling on Congress to eliminate the Section 1031 exchange for gains that are greater than $500,000.

Opposition to the proposed changes

The Federation of Exchange Accommodators (FEA) summed up the opposition to this bill with the following points:

• Section 1031 encourages real estate transactional activity and in so doing stimulates the economy.
• Small exchanges reduce costs for investors allowing them to invest more in providing decent, affordable housing for working families.
• Higher valued commercial real estate exchanges are an important source of jobs.
• Recent research by EY has estimated that like-kind exchanges are expected to generate 568,000 jobs this year, including $27.5 billion of labor income and a total of $55.3 billion of value-added to the US economy.
• The economic impact of like-kind exchanges in their present form is a far better “pay-for” than eliminating this powerful stimulus.”

You can read the full statement here.

Why has Biden proposed these changes and how will this impact landlords?

Like-kind exchanges allow wealthy individuals to avoid paying taxes on capital gains by keeping their money invested. These gains can be made permanent by the individual if they choose to hold onto the property until death. A factor that some people argue has contributed to the growing wealth inequality in America.

By changing this, the US government could create a large new source of revenue from some of the wealthiest Americans. According to the Tax Foundation by limiting like-kind exchanges in this way the Biden administration could generate an estimated $7.5 billion a year in additional tax revenue, by increasing the capital gains tax it was estimated that they could generate an additional $116 billion, and by taxing capital gains at death would raise an estimated $213 billion.

These additional revenue sources are integral to paying for the lost revenue from the 2017 tax cuts (an estimated $1-2 trillion) and the massive stimulus packages that have been implemented over the last year, both in response to COVID-19 and as an investment in America’s future.

Final Words

The proposed changes won’t affect most investors, and of course, these are only proposed changes. However, if you think they might affect you you will want to consult with a licensed professional to form a plan on how to consolidate and structure your investments and reduce your future tax liability.

One thing to bear in mind is the importance of keeping accurate records of your financials including your property appreciation, depreciation, and income and expenses. Knowing your financials is vital to forming a financial plan to minimize your tax liability and to help you achieve your financial goals.