Back in July, advisors for the presidential campaign of former Vice-President Joe Biden unveiled a new economic agenda.
This would normally be uneventful for us.
Not this time.
Biden’s plan explicitly targets real estate investors. In particular, the elimination (or severe restriction) of 1031 “like-kind” exchanges.
This is a bad idea that just won’t die.
Let’s break it down.
Biden wants to spend $775 Billion on “Caring Economy”
News came out of the third installment of the Biden camp’s economic platform. It was unveiled under the moniker “the Caring Economy”.
Details came out during a fundraising event hosted by Blackstone Group President Jonathan Gray.
Here’s what we know about the former Vice-President’s “Caring Economy” agenda (as of July 28, 2020):
– proposal for universal preschool for 3- and 4-year old children
– proposal for increase to child care tax credit
– aim to create more jobs in education and healthcare sectors
– additional aid to state and city governments
– push for more unionization among workers
– elimination of IRC Section 1031 “like-kind” exchanges
– disallowing high-income taxpayers from offsetting real estate losses
– Like most hypothetical agendas, some is paid for through “future growth”
Eliminating Section 1031 Exchanges Is a Bad Idea
1031 exchanges (also called “Starker” or “like-kind” exchanges) allow real estate investors to defer tax payments after they sell real estate — provided that the investor subsequently reinvests in another property.
It’s an enormous benefit to real estate investors, obviously.
But the benefits go much further.
The entire real estate sector benefits from such exchanges, especially
• brokers and agents (more deals)
• banks and mortgage lenders (more borrowers)
• other property owners (more demand for real estate)
• tenants (more and more affordable housing options)
• cities and localities (higher property taxes, more investment)
Don’t just take our word for it.
In 2015, Professors David C. Ling and Milena Petrova (Universities of Florida and Syracuse, respectively) published The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate.
After 93 pages of analysis, Ling and Petrova found:
In the longer run, rents would need to increase from eight to 13 percent to offset the effects of elimination.
That would shrink the supply of available rental space for businesses and individuals.
Price and rent effects would be more pronounced in high-tax states.
“High-tax states” include, among others, California, New York, New Jersey, Hawaii, Oregon and Minnesota.
This study also dispelled the myth that 1031 exchanges are an end-around used by the rich to never pay taxes.
In contrast with the common view that replacement properties in an exchange are frequently disposed of in a subsequent exchange to potentially avoid capital gain and depreciation tax liability indefinitely, we find that in 88 percent of those cases in our dataset investors dispose of properties acquired in a 1031 exchange through a taxable sale.
And even more critically, the taxes paid are often higher than they otherwise would have been.
The estimated taxes paid when an exchange is followed by a taxable sale are on average 19 percent higher than taxes paid when an ordinary sale is followed by an ordinary sale.
UPDATE: Ling and Petrova published a follow-up study in 2020. You can find it here. Below you can read the conclusion in their executive summary.
In other words:
Eliminating 1031 exchanges won’t raise more revenue in the end
It’ll just trade lots of future tax revenue for less current tax revenue. And it’ll put a huge dent in the real estate sector.
The authors sum it up best.
Overall, our analysis suggests that the cost of like-kind exchanges is likely largely overestimated, while their benefits are overlooked. The elimination of real estate exchanges will likely lead to a decrease in prices in the short-run, followed by an increase in rents in the longer run. These negative effects will be more pronounced in high tax states.
Elimination will also likely produce a decrease in real estate investment, increase in investment holding periods, and an increase in the use of leverage.
That’s not all.
Other impact studies revealed the same thing.
For example, a 2016 report by The Tax Foundation found that GDP would shrink by approximately $18 billion each year with repeal of IRC §1031.
In 2015, Ernst & Young projected a $13 billion annual loss.
Like-Kind Real Estate Exchanges Benefit the U.S. Economy
We don’t want to oversimplify any issues here.
Economics is a complicated field. So is tax law.
Making good policy is difficult. It is likely a very good idea to consider all current tax breaks and expenditures when the national debt approaches $27 trillion.
…this is not a difficult call. Eliminating §1031 would be a net drag on the economy and very likely create a net loss to the U.S. Treasury.
1031 Exchanges Spur Capital Investment and Development
The surest way to create economic growth is through capital investment. By “capital”, we mean the technical economic term that includes:
When capital investments improve, so too do production and labor processes. This allows goods and services to improve in quality and decrease in price.
This is the best method yet discovered to improve the average standard of living.
1031 exchanges specifically stimulate capital investment in rental units, office space, mineral fields, and farm/ranch land.
More Business Growth and Flexibility
Small and mid-sized businesses rely on the temporary tax relief and flexibility provided by like-kind exchanges.
→ Your business needs to grow (or downsize) to accommodate a new spike (or decline) in demand
→ You go to sell your current business site, our of which you ran your business for 10 years
→ The new site of your business has better location, more space, and a more appealing aesthetic
→ You try to sell your property
→ Only to find out you owe an extra $1M in capital gains and depreciation recapture taxes
For most small- and mid-sized businesses, this kind of tax bill means they can’t switch to more efficient business operations.
Section 1031 fixes that.
The 2015 Ling and Petrova study highlights capital redeployment as one of the most underrated aspects of tax-deferred real estate exchanges.
Again, the tax relief is almost entirely temporary.
Can’t stress this point enough.
Here’s a simple point, and we don’t want to overstate it.
But it’s always an important idea around election cycles.
There are lots of real estate jobs.
According to the Bureau of Labor Statistics, the real estate sector employed approximately 1.7 million Americans in 2019.
Many of these jobs rely heavily of 1031 exchanges for transaction volume and valuation.
We’ve shared this elsewhere, but the National Association of Realtors estimated that a huge chunk of transactions would disappear without §1031.
We could go on.
But to make a (very) long story (relatively) short,
• 1031 exchanges do not permanently rob the Treasury of needed income
• 1031 exchanges hugely affect both the size and composition of the real estate market in the United States
• Huge sectors of the U.S. workforce rely on the business generated by 1031 exchanges
The Biden 1031 Plan Traffics in Several Myths
Going after real estate investors is probably good politics. It’s just lousy economics.
That said, it is easy to see the attraction to targeting “like-kind” exchanges.
– only going to offend a relatively small voter base
– get to call plays from the Robin Hood economics playbook
– real estate transactions generate large tax bills
– benefits to landlords and developers aren’t popular; programs for the young and elderly are.
It’s a long-standing trope to say that “1031 exchanges favor the rich” at the expense of the working and renting masses.
This is an understandable conclusion if you’ve never interacted with 1031 exchanges or the relevant data.
As we’ve already discussed, the vast majority of 1031 exchangers follow up their exchange with a taxable sale.
As we’ve seen that those sales bring in more tax revenue than otherwise would have generated.
We could go on.
Other common trafficked 1031 myths:
* 1031 exchanges are a net drag on the economy
* 1031 exchanges favor real estate developers
* we don’t need 1031s anymore because of Opportunity Zones
Some of these are debatable. Others are completely wrong.
We like this analysis by Syndicated Equities Principal Tracy Treger – Why Repealing the Use of Like-Kind Exchanges is a Bad Idea.
This was published in 2019, but each argument is just as relevant today.
Response by the FEA
Almost immediately after news broke that the Biden camp wanted to sack Section 1031, the Federation of Exchange Accommodators spoke out.
Here’s the punchline.
In the face of the current COVID-19 pandemic, recession and economic upheaval, the contractionary impact on the U.S. economy and real estate industry would be severe.
Also, the FEA points out that:
- Like-kind exchanges benefit a broad spectrum of taxpayers
- Economic impact studies show that like-kind exchanges stimulate the economy
- The vast majority of exchangers end up paying taxes
- Section 1031 is sound legislatively
- 1031s encourage capital formation, which is the essential building block of economic growth
Here’s the letter in full: