The 1031 exchange has been one of the primary drivers of real estate investment in the United States over the last 4 years.
With this tax strategy, an investor can essentially swap one investment property for another (like-kind) property but the reality is that with President Biden’s ambitious spending plans, the Federal Government has to get money from somewhere.
Even though investors have known that changes to the 1031 exchange were coming, few people wanted to believe that it would happen this soon.
The reality is that where there’s untapped tax revenue, the Government will find it but the big question is how is changing the 1031 exchange going to affect multifamily investors in the United States?
In this article, we will answer this question and I will offer you insight into what the real estate investing market could look like for investors in the years to come.
Anticipating A Big Change To The 1031 Exchange
Thanks to the 1031 exchange, investors have been able to continue to defer paying capital gains on the sale of their investment properties when they roll over the proceeds from the sale of one property into another like-kind property.
In effect, you can change the form of your investment without (as the IRS sees it) cashing out or recognizing a capital gain. That allows your investment to continue to grow tax-deferred. There’s no limit on how many times or how frequently you can do 1031. You can roll over the gain from one piece of investment real estate to another, to another, and another. Although you may have a profit on each swap, you avoid tax until you sell for cash many years later. Then, if it works out as planned, you’ll pay only one tax, and that at a long-term capital gains rate (currently 15% or 20%, depending on income—and 0% for some lower-income taxpayers).2
Most exchanges must merely be of “like-kind”—an enigmatic phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But there are traps for the unwary.
The 1031 provision is for investment and business property, although the rules can apply to a former primary residence under certain conditions. There are also ways you can use 1031 for swapping vacation homes—more on that later—but this loophole is much narrower than it used to be.
Once the changes to the 1031 exchange are implemented, this means that investors who make more than $500,000 on the sale of their investment property will not be able to reinvest the proceeds from the sale of their property into another ‘like kind’ property.
Even though the 1031 exchange has often been billed as a tax ‘loophole’ for wealthy investors, the reality is that it’s not just for the wealthy, it’s a strategy that has benefitted a wide variety of investors for 100 years.
Changes to the 1031 exchange are expected to impact multifamily investors nationwide especially considering that most properties these days cost more than $500K so it’s likely that every investor will be faced with having to pay capital gains on the sale of their property.
A Controversial Change
Anyone who follows the goals of the Biden Administration knows that the Government is going to need a huge increase in funding to close the gap between what the Fed needs to spend on Biden’s programs versus the revenue that they need to bring in.
The tax break has vocal supporters. It’s been part of the U.S. tax code since 1921 and originally covered such situations as when two farmers exchanged livestock. Proponents argue it is a vital tool for small businesses that allows them to upgrade to facilities that better fit their needs without facing big bills.
A 2015 study by academics David C. Ling and Milena Petrova argued removing the tax break could have negative consequences, including reducing liquidity in the market because holding periods would increase.
They also suggested real-estate investment would decrease, property prices would fall in the short-term, and rents would rise in the longer term.
What’s the case for reform?
Simply put, that it unfairly benefits wealthier Americans who can afford to make large investments. Middle-class families, meanwhile, are never likely to own many assets outside their own homes and 401(k)s.
The left-leaning Institute on Taxation and Economic Policy argues the tax break has expanded far from its original intention of supporting small-scale transactions and now involves an industry of brokers who find qualifying properties to insert into the deal. In a 2019 paper, the institute explained how a trade of Midwestern farmland for a Florida apartment could be considered a like-kind exchange.
Will it pass?
The proposal is part of Biden’s wider plan, which includes a range of new social spending, from paid medical leave to tuition-free community college. Some Democratic lawmakers are already urging him to go further and include new health care benefits, whereas some from high-income states are likely to be concerned about some of the proposed tax increases.
With the Republicans unlikely to back the bill and the Democrats with only a narrow majority in Congress, the vote on the overall package could be tight.
Contact Trier Capital
At Trier Capital, our company is a private equity firm that makes it easy for you to passively invest in lucrative apartment building syndications.
Finally, you can invest in tax-advantaged real estate without having to deal with the nuance or complication of purchasing and managing a property yourself.
If you’re an accredited investor who is ready to invest in multifamily properties, contact us today at (630) 229-2383 or click here to connect with us online.