Propmodo Daily

By Franco Faraudo · Mar. 13, 2024

Greetings!

The American real estate market has long enjoyed tax benefits, making it an appealing investment option. One such advantage is the 1031 exchange program, which allows investors to defer paying taxes on the sale of a property as long as they reinvest the proceeds into another property. However, the latest federal budget proposal includes a provision that would eliminate 1031 exchanges. Today, we'll explore the potential implications of this proposed change to the tax code for the real estate industry.

Check out our new article examining the tumultuous state of ESG investing. Originally focused on sustainability, it has devolved into a political battleground. Conservatives are vehemently opposing it, while states are enacting contradictory laws. Caught in the crossfire, real estate firms must carefully navigate treacherous waters as they attempt to balance sustainability objectives with intense scrutiny from all sides.

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Now, let's dig in!

The Complicated Impact of Eliminating 1031 “Like-Kind” Exchanges

The United States is one of the few countries in the world that allows real estate investors to defer paying taxes on the sale of a property as long as they reinvest the proceeds into another property. This tax rule, known as the "1031 exchange," has been in place for over a century, dating back to 1921 during the presidency of Warren G. Harding. Initially, after raising taxes, a study revealed that the higher tax rates led to a significant amount of money being moved offshore or underground. This prompted Harding to cut taxes and introduce the tax shelter now known as the 1031 exchange, outlined in Section 1031 of the tax code.

Over time, there have been changes to the "like-kind" exchange rule, but it has largely remained intact. It is estimated that the annual 1031 exchange transaction volume exceeds $100 billion per year. However, President Biden's new budget proposal includes a provision to eliminate this tax break.

According to the White House's Fact Sheet, "The Budget saves $19 billion by closing the 'like-kind exchange' loophole, a special tax subsidy for real estate. This loophole lets real estate investors – but not investors in any other asset – put off paying tax on profits from deals indefinitely as long as they keep investing in real estate. This amounts to an indefinite interest-free loan from the government. Real estate is the only asset that gets this sweetheart deal."

While saving $19 billion would be a win for the government, the total impact of ending 1031 exchanges is not so straightforward. First, we must remember that the original purpose of the tax code was to prevent money from leaving the country or going "underground." For decades, foreign properties have been ineligible for like-kind exchanges, so it is reasonable to expect at least some capital flight. Other countries offer more favorable tax rates than the U.S., and the growth of unregulated assets like cryptocurrencies provides alternative places for money to be invested.

Another implication to consider is the potential reduction in investment in American real estate due to the tax implications. An impact study conducted by Ernst & Young in 2021, when the idea of ending 1031 exchanges was first proposed, found that these transactions support 568,000 jobs and generate approximately $7.8 billion in federal, state, and local taxes annually.

How the IRS decides to phase out 1031 exchanges will significantly impact the real estate market. If the exchanges are immediately eliminated, we could see many properties being held indefinitely to avoid paying taxes on the growth in value through multiple exchanges. If the program is phased out over time or given an end date, it would likely spark an uptick in transactions as investors rush to complete deals before the window closes.

Real estate transactions are already low, and further suppressing them could cause more pain to the professions involved in property transactions. Moreover, it would eliminate one of the main tax advantages that motivates many to invest in real estate. Given the current political climate in the country, we might very well see the end of 1031 exchanges in the near future, but even if the program is ended soon, the effects are likely to be felt for years to come.

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Propmodo Daily is written and edited by Franco Faraudo with contributions from readers like you and the Propmodo team.

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