New Proposed Tax Plan Seeks To Eliminate 1031 Exchanges


President Biden’s proposed Budget for the Fiscal Year 2024 seeks to promote expanded access and improved affordability in healthcare and education while cutting taxes for low-income families and shrinking the deficit, but the proposed funding comes from increasing taxes on the wealthy and eliminating an important tax break for real estate investors, which will likely be rejected outright by many in Congress. 

Depending on your politics, you might have different solutions to taxes. Many might suggest that changing the tax code to be less advantageous for the wealthy is more complicated than you might think. In this case, Biden’s proposal may unintentionally harm middle-class families in the process, research suggests.

This article takes a look at how this proposal to the tax code could affect real estate investors, in particular.

Raising Taxes for the Wealthy

The proposed budget would increase taxes on wealthy Americans in several ways. For example, it would:

  • Increase the capital gains tax rate from 20% to 39.6% for people earning at least $1 million in any year
  • Increase the Obamacare tax rate from 3.8% to 5% for people with incomes of at least $400,000
  • Levy a minimum 25% tax rate for the wealthiest 0.01%, or households worth $100 million or more
  • Increase the tax rate on personal income from 37% to 39.6% for people who earn at least $400,000, reversing a previous tax cut 
  • Place restrictions on the maximum contribution to Roth IRA accounts for people who earn at least $400,000
  • Removes the step-up in basis for inheritances at death, affecting unrealized capital gains greater than $5 million ($10 million for joint filers) 

It’s important to note that while the effective tax rate for the top 1% has decreased since the 1970s, it’s still more than eight times higher than the average effective tax rate for the bottom half of earners, according to the Tax Foundation. But since the federal government spent $1.38 trillion more than it collected in revenue in 2022, it’s not surprising that policymakers are considering increasing tax rates for the wealthy, especially since wealth disparities were narrower in the years when high-earners paid more. Research belies the claim that cutting taxes improves the economy, and the government collects less revenue when tax rates are lower, so raising rates for at least some taxpayers may be essential.

There are, however, some unintended consequences of raising capital gains taxes above the threshold. For example, homeowners who earn far less than $1 million or even $400,000 annually may get stuck with a tax bill for selling a home in a hot market, where a $1 million home isn’t a mansion — it’s a median-priced single-family home. For example, the median home price in San Francisco sits at about $1.3 million, even after declining this past year. Even with the capital gains exclusion for primary residences, a homeowner who bought a property 20 years ago in what has become a hot market could potentially get dinged at the higher rate in the year they sell. That could make affording a similar home at today’s high mortgage rates difficult to achieve for movers. 

It’s unclear how many people will fall into this category. But it’s worth questioning whether certain exceptions may be necessary and whether the capital gains tax increase is the best way to accomplish the federal government’s goals. For example, critics say an increase in the capital gains tax rate discourages saving. The Congressional Budget Office estimates that a tax on consumption, which would encourage saving over spending, would have the greatest impact on shrinking the deficit—but this would also disproportionately impact low-income earners. There’s no easy solution. 

Eliminating 1031 Exchanges

Another aspect of the proposed budget is the elimination of 1031 “like-kind” exchanges for real estate investors, which have been around since 1921. Section 1031 of the tax code allows individuals to defer paying capital gains tax on an investment property by using the proceeds from the sale to purchase a similar property of equal or greater value. A fact sheet from the White House compares the tax benefit to an “indefinite interest-free loan from the government” and categorizes it as “wasteful spending on special interests.” 

There seems to be a misconception that real estate investors are already wealthy and insatiably greedy, and that they avoid paying a fair tax rate while exploiting their tenants for more income. Perhaps the framing of policy initiatives perpetuates the stereotype, but in the vast majority of cases, that’s patently false. The 1031 “loophole” doesn’t exclusively benefit the wealthy—it benefits real estate investors from all walks of life. 

Mom-and-pop landlords own 41% of all rental properties and nearly 73% of all two to four-unit buildings. These are not people earning $1 million annually—the estimated average annual income for landlords is $97,000. While real estate is often touted as the preferred investment vehicle for the ultra-wealthy, it’s also a tool for everyday people to boost their retirement savings and save enough to send their kids to college. Small deals for inexpensive properties make up the majority of like-kind exchanges. 

Furthermore, research shows there’s nothing wasteful about the like-kind exchange tax break—it plays an important role in encouraging economic activity and revitalizing communities and added $97.4 billion in value to the U.S. GDP in 2021. Like-kind exchanges make investment more efficient, creating hundreds of thousands of new jobs. They also make it viable for investors to convert vacant commercial spaces into apartment buildings, something that’s important to encourage during today’s housing shortage. The National Association of Realtors offers a few anecdotal examples of how 1031 exchanges have enabled investors to rejuvenate communities. 

Critics say the removal of 1031 exchanges would reduce federal revenue, exacerbate housing shortages, and lead to a decline in housing quality for tenants since property owners would have less incentive to upgrade their units with new kitchens and bathrooms. Companies may also be discouraged from relocating to buildings that better meet the needs of the business and employees. While it’s possible there could be a benefit to placing limitations on 1031 exchanges, eliminating them entirely would likely have adverse negative effects on the economy, research suggests. 

The Bottom Line

There’s a strong argument for increasing taxes on the wealthy to fund social programs. It may not be the only way to improve economic mobility, pull people out of poverty, and shrink the wealth gap, but it’s a potential solution—even some notable billionaires have come out in support of the idea.

But in the process of reforming the tax system, policymakers need to be careful that proposed solutions do not unintentionally harm low-income and middle-class families and communities or real estate investors who contribute to the economy in a positive way.

tax book

Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

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