President Biden’s proposal to sharply raise taxes on capital gains and eliminate the 1031 exchange has created anxiety and frustration across the $1 trillion multifamily real estate Industry. The industry plays a vital role in providing housing to 40 million Americans, along with creating countless jobs in construction, property management, technology support, and accounting and legal services. The housing and rental ecosystem was estimated to contribute more than $3.4 trillion to the national economy in 2019 alone. Inexplicably, all of this value is being ignored with a misguided belief that the 1031 somehow only helps the uber rich. For a century, the Internal Revenue Code (IRC) has offered a tax deferral provision, known as the 1031 exchange, that allows real estate investors to replace a property with a same-like property of greater or equal value. And unlike some in Washington have suggested, it is hardly a loophole to benefit taxpayers at the expense of the US Treasury. In reality, investors receive no cash during the exchange of properties, and are left in the same tax position as if the relinquished property was never sold. While taxes may be temporarily deferred, they are never eliminated. Notably, the 1031 exchange has endured the political scrutiny of both Republican and Democratic Administrations since 1921, the year the 1031 exchange was first enacted. Add to that, current proposals to limit or repeal the 1031 exchange fail to account for the economic consequences on the vibrant real estate industry and the total U.S. economy. A 2015 comprehensive study conducted by Ernst & Young found that the repeal of the 1031 exchange would shrink the U.S. economy by $13.1 billion annually, result in less federal tax revenues, and discourage new real estate investments. And a recent industry survey showed that 60% of exchanges deal with properties worth less than $1 million. Counter to what many will have you believe, a repeal of the 1031 exchange will have an economic impact on many small operators who are all part of the American dream of building wealth over time. Contrary to the popular belief that 1031 exchanges provide an indefinite tax deferral, an academic study found that 88% of properties acquired through a 1031 exchange are eventually sold in a taxable sale. In reality, a repeal of the 1031 exchange would severely curtail the volume of activity in the real estate market and negatively impact tax revenues resulting from transfer taxes, mortgage taxes, recording fees and income tax revenue from real estate professionals such as brokers, attorneys, CPAs, lenders, and title insurance companies. Recent academic research also provides additional evidence that when investors use the 1031 exchange, they make larger investments in subsequent property acquisitions, thus generating more opportunities in the sector and increasing the much-needed supply of rental properties in the U.S. In the like-kind exchange, the average incremental investment is in the range of $305K to $422K more than the relinquishing property, and the differences between replacement and relinquished property prices range from 8% to 33%. Section 1031 also encourages turnover and investment of fresh capital in these properties, improving neighborhoods, and providing additional capital expenditures for renovations to improve tenants’ environments. The multifamily real estate market is intricately linked with the construction industry, professional services, the labor market, and many other subsectors of the U.S. economy. Repealing the 1031 exchange will alter investor motives, reduce the frequency of property transactions, and slow down fresh capital expenditures for renovations, all while potentially increasing rental rates from reduced supply of properties. While the Biden administration argues that taxes will be paid by the wealthy and billionaires, it is highly questionable that the proposed legislation for eliminating the 1031 exchange will actually achieve this goal. Instead, proposed changes will likely redirect the burden of taxation to the overwhelming majority of Americans who are involved in multifamily real estate, the majority of whom are not millionaires.
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Albert L. Lord III is the Founder and Chief Executive Officer of Lexerd Capital Management LLC. Lexerd is a real estate firm that primarily sponsors investments in opportunistic multifamily assets throughout the United States. The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc
This article authored by Al L. Lord III, was published by Nasdaq Inc. May 18, 2021