- President Biden renewed his pledge to end the 1031 exchange, a popular tax deferral tool.
- Real estate investors said the downside from that action could offset any gains.
- They said one impact of the shutdown could be to push investors out of real estate.
President Joe Biden said last week he wants to close a tax “loophole” that allows corporations, wealthy people and everyday home sellers to avoid paying capital gains on long-term investments like real estate.
The administration’s proposed 2024 budget specifically targets the “like-kind exchange” — or 1031 exchange, as it’s more commonly known — that allows home sellers to defer paying taxes on any capital gains if they quickly reinvest funds in another, similar property .
Ending the peer-to-peer exchange could add $19 billion to the budget, Biden said.
While the Biden administration has described 1031 as a “sweetheart deal” and an “indefinite interest-free loan from the government,” real estate investors with decades of experience and thousands of rental units told Insider they believe something similar will end. -Exchanging goods could cause more harm than good. They said removing the incentive to return money from a long-term property investment would drive many investors away from real estate and potentially cause demand for homes and property prices to fall.
Of course, real estate investors—from small mom-and-pop landlords to large corporate firms—will want to protect their wealth and will respond to any move to end the 1031 exchange with friction.
A Democratic Senate and Republican House of Representatives must both pass the proposed budget, and it will likely face stiff opposition. As Insider’s Juliana Kaplan and Ayelet Sheffey wrote, the administration’s budget is more of a list of priorities than proposals that will actually see the light of day.
Investors will have little incentive to keep their money in real estate
Getting rid of the 1031 exchange would have a major impact on how people decide whether to invest in real estate in the first place, two investors said.
“The 1031 exchange was created so that people could keep their money in the housing market and not get it out,” Matt Picheny — who said he has invested, both as an individual and with partners, in a total of 10,000 rental units across the US for the past 17 years — he told Insider. “I don’t see this as a tax loophole – this is a strategy that the government has put in place on purpose to induce business owners to take certain actions.”
The tax deferral from a like-kind exchange is a means of pressuring investors to put their money directly into the housing market rather than putting it into other assets or simply spending the cash, Picheny said.
Eliminating the 1031 exchange and requiring real estate players to pay taxes on a property’s capital gain, which can be as much as 20% of what one makes on their original investment, would reduce one’s purchasing power. And if it is repealed, real estate investors may have to explore other ways to avoid costly capital gains, such as placing real estate in a trust or simply keeping a property in their ownership forever.
“If you’re getting a big return on a deal, then it probably makes sense to go ahead and sell it. But why invest again?” Picheny said. “You’ve already paid the taxes, or you might decide to invest a little less.”
It could lead to slower sales or even lower home prices
If real estate investors spend less on real estate, it could, in turn, have broader effects on the broader economy, Picheny said.
“1031 is so ingrained in the business that removing it would be disruptive,” Picheny said. “Getting rid of the 1031 would decimate the market. It would cause values to drop very significantly.”
In other words, removing a major incentive for people to reinvest their cash back into the market would simply mean that there is less interest in real estate as a form of investment. And spending the money raised from real estate equity on anything other than real estate—from stocks to crypto—could lead to less demand for homes and, as a result, lower property values.
Steve Davis, a real estate investor who said he has flipped 100 houses and has stakes in 4,000 condos over the past three decades, also said that eliminating the 1031 tax tool would “suffocate” the real estate industry as a whole.
If investors feel less motivated to put the money they make from selling a property back into the market, they could spend that money on other things, such as cars or vacations, Davis said. He called 1031 a “control tool” that keeps investors’ capital in real estate and in turn increases the wealth of the nation’s economy by having more money — and tangible wealth — locked up in the real estate market.
Investors can be better served, Davis said, by leaving their equity locked up in an asset — such as an apartment building — and then living off the rental income it generates. Conversely, if the 1031 is repealed and someone sells a multi-unit building on which they have to pay a large capital gains tax, there wouldn’t be as much of an incentive to reinvest the money into a new building. As a result, Davis added, property owners could end up using their original investments to pay their bills.
“1031 was forcing people to never kill the golden goose because your equity is the golden goose and it generates cash flow,” Davis said. “You’re supposed to live off the cash flow, not the goose. If they take away the 1031 exchange, there’s no incentive not to eat the goose. So people will start spending that money and less of it goes back into real estate.”