In economics there is no free lunch and you can’t spend forever without paying the piper. A new recent tax proposal keeps spending while drastically increasing taxes on real estate owners. The new plan eliminates the 1031 exchange and the step up in basis upon death. Furthermore capital gains will be taxed at ordinary income. What do these changes mean for real estate owners? Will his proposals actually pass?
What is in President Biden’s new tax plan?
There are three primary pillars that will impact residential and commercial real estate with huge jumps in taxes.
- Elimination of the 1031 exchange
- Long term capital gains taxes as ordinary income
- Elimination of the step up in basis
Your taxes will increase $775 Billion dollars according to an analysis by Bloomberg. Presidential nominee Biden has rolled out his proposed tax plan with two major pillars that will impact real estate pros. 1) Elimination of the 1031 exchange provision 2) elimination of long term capital gains 3) elimination of a step up in basis. These three changes, if passed, will have huge implications for taxes, real estate values, rental rates, employment growth, and real estate investing in general.
What is a 1031 exchange?
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.
The 1031 exchange can be used for both commercial and residential investment property. For example, if you owned an industrial building, you could sell the property and “exchange” it into another property and defer the tax liability. The 1031 exchange does not eliminate taxes, it merely defers them to a later time.
There is a market misconception that 1031 exchanges primarily benefit large scale wealthy investors. The reality is that the majority of exchange transactions are under one million meaning the majority of the beneficiaries are smaller investors.
If the 1031 exchange were eliminated what is the impact on real estate and the economy?
In 2015 there was a proposal to eliminate the 1031 exchange. A study was done by professors at the University of Florida to understand the true impacts of the 1031 exchange and the implications on the benefits of a program. Below are some of the key findings
We also develop a “typical project model” to estimate the range of short-run declines in
prices that would be necessary to offset the increased tax burden of eliminating like-kind
exchanges. In local markets where investors are moderately taxed, we estimate that prices on typical office, industrial, retail and other commercial properties would have to decline eight to 12 percent to maintain required investment returns. In the longer run, rents would need to increase from eight to 13 percent to offset the effects of elimination. Price and rent effects would be more pronounced in high-tax states.
In addition to using some of the deferred gains to increase the size of their investment
in subsequent properties, investors in like-kind exchanges use less leverage than ordinary investors to acquire replacement properties.
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.
These micro effects are likely to have macroeconomic consequences as well. For example, a reduction in real estate activity, resulting from lower investment and prices decreases, would lead to slower growth rate in employment, especially in the markets where like-kind exchanges are commonly used.
Long term capital gains also eliminated leading to a huge increase in taxes
The fallback for elimination of the 1031 exchange would be to hold the property for 18 months to get a lower capital gains tax rate of as low as 20%. Unfortunately, the long term hold strategy is also going by the wayside.
Biden’s plan would raise taxes on capital gains by treating them as ordinary income for those earning more than $1 million. On his website he said he would also raise the top rate on ordinary income back up to 39.6 percent from the 37 percent rate put in place by the Tax Cuts and Jobs Act and adds a Medicare surcharge. As such, the top rate on long-term gains would nearly double from 23.8 percent to 45% percent.
Largest impact on commercial properties
Commercial real estate is already on track for a very challenging year with higher cap rates and reduced lease rates, adding on profound change like the elimination of the 1031 exchange will be catastrophic for many property owners. For example, let’s say someone owned an office property, with everything going on, the owner would likely be inclined to exchange into another more productive property like industrial. With the elimination of the 1031 exchange, the property owner could be facing a tax bill up to 40% so they make the decision to hang on to the underperforming property. The subsequent economic impacts are that capital is not optimally utilized. Furthermore, banks, title companies, realtors, exchange companies, contractors, etc… are also going to be underutilized.
A good comparison is what happened to business travel due to the pandemic. All of the industries surrounding business travel from restaurants, hotels, conference centers, airlines, etc… are impacted due to the loss in movement of people. The commercial real estate industry will incur similar ancillary impacts with the elimination of the 1031 exchange as transaction volumes drop substantially.
Eliminate the stepped-up basis:
- A step-up in basis reflects the changed value of an inherited asset. For example, an investor purchasing shares at $2 and leaving them to an heir when the shares are $15 means the shares receive a step-up in basis, making the cost basis for the shares the current market price of $15. Any capital gains tax paid in the future will be based on the $15 cost basis, not on the original purchase price of $2.
- The new tax proposal eliminates stepped up basis: For example now if you inherit a property that your parents bought for 100k, that is now worth 1m, your tax is now based on the 100k so your gain is 900k that you would pay taxes on.
Unintended consequences of step up in basis elimination
Who does the proposed tax law effect the most?
The current administration continues to emphasize that this new tax bill will only affect the highest earners, unfortunately this couldn’t be farther from the truth, the impact will be felt primarily by the middle class and property owners regardless of their wealth.
- Farmers/ Ranchers/ Rural property owners: Farmers are typically asset rich and cash poor. Farming and Ranching are very capital-intensive activities with the majority of their wealth tied up in land. For example, a rancher could have inherited 1500 acres that they use to graze cattle on. When the owner passes away and the asset is transferred to the next generation a huge taxable event occurs. Here is a quick example: assume the land has been in the family for 50 years, the basis on the land is pretty close to zero so the tax due would be enormous. The land is now worth 5k/acre, so a total value of 7.5m. Under the new law the max deduction is 5 million that leaves 2.5million taxable at long term capital gains rates. The heir would be on the hook for 500k now. In the ranching business, I doubt they have 500k lying around to pay taxes!
- Small business owners: Similar to Ranchers, many small business owners have substantial assets tied up in their business that are not liquid. For example, a family-owned roofing company could have numerous trucks, forklifts, cranes, etc… When the business transfers to the next generation taxes are now due and payable which creates huge liquidity issues for the heirs and will force a sale of many small businesses.
- Middle class: On the surface a 5 million estate tax exemption seems huge, but with the elimination of a stepped-up basis it is not hard to easily hit this cap as assets and businesses have appreciated over many years. Take for example a person has been acquiring residential rental properties or a small apartment complex. With the historical appreciation and recent run up in real estate, the heirs could be looking at an enormous tax bill without the liquidity to pay.
Unlikely this tax plan will pass any time soon
Fortunately with a divided legislature and executive branch, the probability of passage at this point seems low. On the flip side, the same themes on taxation continue to resurface regarding the elimination of the 1031, elimination of long term capital gains, and the elimination of the step up in basis so it is important to watch to see where we might be heading in the future. Unfortunately I think we are just at the beginning of the taxation question and it looks like real estate will be in the cross hairs.
Additional reading/Resources:
- https://www.bloomberg.com/news/articles/2024-03-11/capital-gains-hikes-at-center-of-biden-s-second-term-tax-agenda?srnd=homepage-americas
- https://www.fairviewlending.com/biden-tax-plan-impact-on-property-owners/
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Glen Weinberg, personally writes all these blogs based on my real estate experience. I’m not an armchair reporter/writer. We are an actual private lender, lending our own money. We service our own loans and own commercial and residential real estate throughout the country.
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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