It’s official. The United States of America has a new President, its 46th since the US Constitution was established in 1787. The transfer of power this time around was a rocky one, but President Biden’s swearing-in on January 20th is in the history books and we now focus on his “first 100 days” where most of the components of his campaign platform should begin to take shape.
The first 100 days are critical in the sense that a new president’s political capital is the most potent early on, as expectations are high and the prevailing winds from the election are generally at the back of the incoming chief executive.
To be sure, there are many major issues on the political front that will get much of the initial attention. We are in the midst of a pandemic that has decimated businesses large and small, and sent millions onto the unemployment rolls. Even multiple vaccines developed to fight the virus have become political footballs that are slowing their dissemination to vulnerable groups.
The list of other issues is a long one, but we have a different focus: President Biden’s proposals to raise taxes on multiple fronts, several of which will directly impact commercial real estate if just one or any combination thereof become the law of the land.
Last week we took a high level look at several of his proposed tax increases that include raising marginal income tax rates, taxing capital gains at ordinary rates, eliminating 1031 exchanges, doing away with the step-up rule, lowering the threshold for estate taxes and taxing estates at higher rates, along with increasing corporate income tax rates. The entire list is formidable to say the least. To read our preliminary thoughts on the foregoing, click here. In that post, we promised to take a look at the proposals that would impact commercial real estate investing the most. We decided to start with the issue of tax-deferred exchanges, most commonly referred to as 1031’s. Bear with us, this could run a bit long. So, your patience is appreciated.
The IRC 1031 exchange provision of the tax code is now officially 100 years old. It was originally conceived to encourage accelerated investment and preserve and grow wealth in a variety of asset classes, including real estate. As it stands today, real estate is the last of those asset classes eligible for a so-called ‘like kind tax-deferred exchange’, whereby the proceeds from the sale of an asset can be re-invested in another investment property of ‘like kind’ without precipitating a taxable event until the last acquired property in the chain is ultimately sold. This allows all the equity in a property to be reinvested, without a cut for taxes, which allows the exchanger to acquire a higher-valued asset as his up-leg and/or have more capital to reinvest in and improve that asset to create additional value.
As a real estate investor, you probably already know this, but we think it bears repeating as we delve into the changes proposed by our new president, who now has an undivided legislature to work with toward achieving his stated objectives. It is important to note that it only takes a simple majority in both houses of Congress to pass tax legislation through the use of a procedure known as reconciliation. Thus, the Senate’s filibuster rule is not the firewall it is on non-fiscal legislation.
So, exactly what is President Biden planning to do as it relates to 1031 exchange rules? Simply put, he plans to eliminate them. Sound drastic to you? It sure does to us. So, we decided to go down the rabbit hole and learn everything we could about the impact of exchanges on the commercial property market. In a matter of days we confirmed a lot of what we already knew and learned a whole bunch more. In particular, we came across the definitive study on the topic, The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate, published in 2015 by two widely respected college professors, Richard Ling of the University of Florida & Milena Petrova of Syracuse University. You will find links to the study and a recent update at the end of this post.
Essentially, their conclusions emphatically endorse the 1031 exchange concept as an engine of capital formation and economic growth, as well as its impact on job creation and, yes, even more tax revenue to the federal government. They confirmed for us our contentions that 1031 exchange activity:
- Increases the number of sale transactions and the flow of investment capital at all price levels
- Encourages additional capital investment into properties to enhance value after acquisition
- Creates and sustains employment in a broad base of industries
- Accelerates wealth creation that promotes further capital investment
- Improves the quality of life for investors willing to take on the risk of property ownership
They also warned us that the elimination of the 1031 exchange rules would:
- Lower transaction volume
- Lengthen holding periods
- Reduce property values/Raise cap rates
- Increase market risk
- Lessen buyer demand
- Decrease liquidity
- Elevate the use of leverage in property acquisitions
- Lower actual tax revenue the US Treasury
We like the first set of bullet points much better than the second, and you are likely to, as well. It seems hard to imagine a deliberate attempt to unravel one of the fundamental elements of real estate investing, but that is, it seems, exactly what President Biden intends to do. Whether he will get to this issue in his first 100 days or even in his first year in office, is unknown at this point. But, it sure is a wake-up call for anyone who had plans to dispose of his or her assets in the near future.
We will drill down a bit deeper on these lists in our next post and will keep them coming as quickly as possible to help you understand better how each of the proposed tax hikes could impact your portfolio and your life plan. Stay tuned for more, but please do give us a call if you have any questions or thoughts on these issues as we lay them out for discussion.
- Microsoft Word – Ling Petrova Economic Impact of Repealing or Limiting Section 1031 6-22-15.docx (ipx1031.com)