With the national election just around the corner, it makes sense to focus on the major platform components of both candidates and do our best to filter out the hyperbolic rhetoric that often accompanies presidential politics.
In the usual fashion, the incumbent runs on a purported record of successful actions taken in a first term, while the challenger tries to downplay that success in favor of a new vision for the country that runs in the opposite direction. In that sense, this election may be no different than any other, though the level of angst and vitriol from both sides has reached unprecedented levels.
With our political filters on maximum, in this post we take a look at the challenger’s proposal to eliminate two important components of the tax code that would drastically impact commercial real estate and its role in retirement and estate planning: the 1031 exchange and the step-up rule.
The IRC 1031 exchange model, which allows investors to defer capital gains taxation as they build real estate portfolios over time, has been around for a long time. And so has the step-up rule, which offers investors the opportunity to pass their portfolios to their heirs at a step-up in basis to their property’s value at the time of death, effectively eliminating capital gain and depreciation recapture taxes on entire portfolios so long as a simple set of rules are adhered to. It is commonly referred to as the “swap ‘til you drop” strategy, an accurate if morbid description. This time-tested and fully vetted strategy has served millions of investors well for decades. In fact, most of you reading this post are probably employing it as part of your own exit plan.
The existence of these two rules are foundational to the value structure of commercial real estate, and their elimination would have enormous consequences. Just the threat of such a significant change could cause substantial damage, as nervous property owners would likely decide to dispose of assets and disrupt the supply/demand balance overnight. Looking longer term, the flow of capital in commercial real estate would slow down, as every transaction that closes would become a taxable event. Investors would also shift their allocation of capital to more liquid asset classes, not wanting to be stuck with too much real estate, which is, by its nature, low on the liquidity continuum. Illiquidity is already one of the biggest risks associated with owning real estate. Anything that would exacerbate that risk would certainly add a yield premium, lowering property values across the board.
The elimination of the step-up rule could also have disastrous consequences. Its existence is the main reason why countless investors continue to hold real estate assets. It is their opportunity to see that their heirs reap the benefits of decades of hard work, risk-taking and savvy investing. For individual estates valued over approximately $11.2 million, there is already an estate tax of 40% to contend with under existing law. With the elimination of the step-up rule, heirs would inherit the original basis of the investor and be subject to massive capital gains taxes when the properties they inherit are sold.
We don’t know if these changes will actually be made if the challenger becomes President. Enacting any new laws will depend on the balance of power in the Legislative branch. In a divided government where the houses of Congress are controlled by opposite parties, getting anything done is difficult, and that was by the design of the Founding Fathers. They knew the political winds would blow in both directions and sought to encourage cooperation and compromise between the majority and minority voices in government. We are grateful for their vision and hope that those currently in power are, as well.