The IRC 1031 Exchange Provision, Clinton tax proposals, and how a Hillary Clinton presidency could impact your real estate investments.
With so much talk about the upcoming election on Tuesday, we’ve been doing a little research on what the presidential candidates have in mind for changes in the tax code if elected.
Both candidates are claiming tax reform and both are threatening to modify the current IRC 1031 Exchange Provision of the US Tax Code. It didn’t take a whole lot of digging to discover some things that Hillary Clinton is proposing that, quite literally, shocked us.
Given that her reform is so much more drastic than Donald Trump’s, we choose to focus on her proposals for this edition. We’ll try and post on Donald’s stance before Tuesday…
If you can tolerate some bad news, read on. If not, don’t. It ain’t pretty.
Real Estate and IRC 1031
Real estate investing offers a number of basic advantages. Real estate is tangible, it can be depreciated, it can be financed for positive leverage and, if properly maintained and managed, its income can be enhanced with time.
All that is good stuff, but one of the biggest advantages of owning real estate, is realized through the use of the IRC 1031 Exchange provision in the US Tax Code.
It allows capital gains and depreciation recapture taxes to be deferred if the real estate is exchanged for property of “like kind”, giving investors a chance to grow their equity without paying Uncle Sam until they decide to cash out.
The like kind rules are broadly defined, allowing real estate investors the flexibility to acquire different kinds of real estate over time, depending on market conditions. So, the owner of an office building can exchange it for a multi-family property to take advantage of potentially higher returns or to mitigate investment risk.
Currently, there are no limitations on the amount of capital gain that can be deferred. That would all change if Ms. Clinton becomes Madame President.
According to her published proposal, a maximum of $1 million in gain per year would be eligible for deferral even if a property is exchanged via the 1031 provision.
This could have a devastating impact on commercial property investors with gains above that threshold, which, by the way, is most investors given current market conditions.
If such a rule were enacted, it would immediately reduce the value of commercial real estate, as the burden of illiquidity it carries would be given greater weight relative to stocks, bonds and other more liquid asset classes. Why take the risk if the benefits are removed from the equation?
The rule would also encourage investors to keep their existing assets for much longer, which would reduce transaction activity and expose property owners to market corrections, as they will have to make a choice to cash out and suffer the taxable event, or hold on tight and ride out the correction.
Neither of those options are palatable to many investors, especially older ones, who may not have time to wait out another real estate cycle.
Changing the 1031 rules would also cause a major shift in who owns US real estate. To be sure, real estate ownership would become more institutional, as the big players acquire massive portfolios, generally hold properties long term and have different taxation concerns.
Investment Trusts and Capital Gains
Real Estate Investment Trusts would probably become more popular, as shares in those entities are bought and sold just like any other stock, thereby allowing for shareholders to ostensibly invest in real estate and maintain liquidity at the same time. The good ol’ days of mom & pop investing would be changed forever.
Ms. Clinton also wants to raise capital gains tax rates and extend the holding period for long term capital gains tax treatment, which would only exacerbate the problems created by the changes to the IRC 1031 exchange provisions.
So, those investors who decide to sell and cash out, versus hold for the long term, will do so at a higher cost, a fact likely to discourage new investors from entering the market.
Thus, demand would decrease and prices would fall accordingly.
Under current capital gains tax rates, most potential sellers are disinclined to sell their properties. It’s hard to imagine that problem getting nothing but worse if the tax rates moved higher.
We believe that value-add investing will be hit in states like California, property tax revenue would also decline, as the tax burden for each property is determined at the point of sale. Highly appreciated assets sold under current market conditions, sometimes see a many-fold increase in property taxes.
If those same properties stay in the hands of their current owners, then property taxes are limited to a 2% increase each year.
Income and capital gains tax receipts would also fall, as property sales that would otherwise generate taxable income won’t take place.
We are guessing that Ms. Clinton did not have these undeniable facts in mind when she concocted her plan.
There is so much more to discuss on this potentially explosive issue, but the election is just a few days away, and the result will be a game changer either way.
If Ms. Clinton manages a victory, we will be taking another hard look at these issues next week. If she doesn’t, we will do our best to sort out her opponent’s proposals in terms of their effects on real estate investing.
Hang on to your hats, folks. Either way, things are going to get interesting.
What About Trump?
Interested in what we have to say about Donald Trump’s tax proposals? Sign up for our mailing list. We’ll send you a friendly email when the follow-up to this post is released.