Real-estate investors said eliminating a popular tax-avoidance tool would damage the economy
- President Biden has renewed his commitment to ending the 1031 exchange, a popular tax-deferral tool.
- Real-estate investors said the negative consequences of doing so could outweigh any gains.
President Joe Biden said last week that 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 postpone paying taxes on any capital gains if they quickly reinvest funds into another, similar property.
Ending the like-kind exchange could add $19 billion to the budget, Biden said.
While the Biden administration described the 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 under their belts told Insider that they believe ending the like-kind exchange could cause more harm than good. They said taking away the incentive to put money made from a long-term real-estate investment back into the market would drive a lot of investors away from real estate and potentially cause demand for homes and property prices to slump.
Of course, real-estate investors — from small-time mom-and-pop landlords to big corporate firms — will want to protect their wealth, and will meet any move to end the 1031 exchange with friction.
A Democratic Senate and Republican House of Representatives both need to approve the proposed budget, and it will likely face fierce opposition. As Insider's Juliana Kaplan and Ayelet Sheffey wrote, the administration's budget is more a list of priorities than proposals that will actually see the light of the 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 determine whether to invest in real estate in the first place, two investors said.
"The 1031 exchange was created so that people will keep their money in the housing market and not pull 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 over the last 17 years — told Insider. "I don't see it as a tax loophole — this is a strategy that the government put into place on purpose to induce business owners to take certain actions."
The tax deferral from a like-kind exchange is a means of putting pressure on investors to put their money right back into the housing market instead of putting it into other assets or simply spending the cash, Picheny said.
Eliminating the 1031 exchange and making real-estate players pay taxes on the capital gain of a property, which can be up to 20% of whatever someone makes over their original investment, would reduce someone's purchasing power. And should it be abolished, real-estate investors might have to explore other avenues to avoid costly capital gains, such as placing properties in a trust or simply perpetually keeping a property in their ownership.
"If you get a great return on a deal, then it probably makes sense to go ahead and sell it. But why would you invest again?" Picheny said. "You've already paid the taxes, or you might decide to invest a little bit less."
It could lead to slowing sales or even lower home prices
If property investors spend less on real estate, it could, in turn, have wider implications on the broader economy, Picheny said.
"The 1031 is so ingrained in the business that removing it would cause an upset," Picheny said. "Getting rid of the 1031 would decimate the market. It would make values plummet very substantially."
In other words, taking away a major incentive for people to reinvest their cash back into the market would simply mean there is less interest in real estate as a form of investment. And spending the money gained from real-estate equity on anything other than real estate — from stocks to crypto — could result in less demand for homes and, as a result, lower property values.
Steve Davis, a real-estate investor who said he has flipped 100 homes and held stakes in 4,000 apartments over the last three decades, also said the removal of the 1031 tax tool would "stifle" the real-estate industry as a whole.
If investors feel less incentivized 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 the 1031 a "control tool" that keeps investors' funds in real estate, and in turn, grows the wealth of the country's economy by having more money — and tangible wealth — locked up in the real-estate market.
Investors can be best served, Davis said, by leaving their equity locked into an asset — such as multiunit apartment building — and then living off of the rental income it generates. Instead, if the 1031 is abolished, and someone sells a multiunit building that they have to pay a steep capital-gains tax on, there wouldn't be as much of an incentive to reinvest the money in a new building. As a result, Davis added, property owners could end up using their original investments to pay their bills.
"The 1031 was forcing people to never kill the golden goose, because your equity is the golden goose and it produces 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 are going to start spending that money, and less goes back into real estate."
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