By: Matthew Capelli
President Biden proposed to limit the like-kind exchange in his April 2021 American Families Plan.1 This proposal would negatively affect real estate because real estate investors would not be able to defer capital gains taxes when they exchange property.
Under current law, a real estate investor does not recognize gain “on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”2 To qualify for a 1031 exchange, a real property seller has 45 days to find and specify a replacement property equal or greater in value to the sold property, spend their equity, replace the debt from the sold property on the specified property, and close on the specified property in 180 days.3
Essentially, a 1031 exchange, commonly referred to as a “like-kind” exchange, allows real estate investors to change the form of their investments. Moreover, section 1031 gives real estate investors the ability to grow their investment when they upgrade and exchange properties by allowing them to defer taxes without cashing out and recognizing a capital gain.4
President Biden’s tax proposal (“Proposal”) directly affects real estate because it would end 1031 exchange tax deferrals for capital gains greater than $500,000.5 For example, assume real estate investor A purchased an apartment building in all cash with a basis of $10 million in year one and sold it for $12.5 million in year five. A has a capital gain of $2.5 million. Under current law, A can defer her total capital gain and reinvest those proceeds in another apartment building if A follows the applicable section 1031 rules mentioned above. Under President Biden’s plan, A can defer $500,000 in capital gains but would have to cash out and recognize a $2 million gain and pay capital gains taxes on it. Assuming A pays the current 20 percent capital gains tax rate plus the 3.8 percent net investment income tax surcharge, A will pay $476,000 in capital gains taxes.6 Therefore, assuming A wants to reinvest her proceeds in a new apartment building, A will only have $2,024,000 to invest, compared to $2.5 million under current law.
President Biden’s Proposal will negatively impact real estate because it will increase prices. Specifically, this will affect apartment tenants, who saw a record 11.5 percent increase in national rent prices over the past year.7 Real estate investors, like other investors, are profit-seeking and want to maximize their after-tax returns. If real estate investors cannot defer all their capital gains taxes with a 1031 exchange, they will pass the increase in taxes onto their tenants to meet their internal rate of return and cash on cash requirements. Furthermore, real estate investors will have to use more debt because they will have less cash to reinvest in a 1031 exchange. Thus, rents will increase because landlords will need to recoup the lost money paid in additional taxes and increased debt payments.8
The Proposal will also negatively affect real estate investment trusts (“REITs”) because it will limit the ability of REITs to take advantage of section 1031 to ensure compliance with rules against prohibited transactions.9 Specifically, a REIT must “not make more than 7 sales of property” each taxable year.10
If a REIT completes prohibited transactions, it must pay a “tax equal to 100 percent of the net income derived from [the] prohibited transactions.”11 Basically, if a REIT sells eight properties in a taxable year, it must pay a tax equal to all the profits it receives from the sale of the eighth property. Under current regulations, when a REIT transfers property using a 1031 exchange, the transfer is not considered a “sale” counting towards the yearly seven sale limit.12 Thus, REITs can improve and modify their portfolios to the benefit of their shareholders without incurring the prohibited transaction tax.13
Under the Proposal, REITs will be limited in their use of 1031 exchanges because they will not be able to defer taxes on gains greater than $500,000.14 The $500,000 gain limitation will heavily restrict how REITs can modify their portfolios because many REITs acquire and sell stable and trophy properties with strong leases in place that create millions of dollars in gains. For example, last March, the REIT Vici Properties Inc. acquired the Venetian casino resort and its convention center in Las Vegas for $4 billion and subsequently leased the property to an Apollo Global Management portfolio company for $250 million a year for an initial term of 30 years.15
Unfortunately, the Proposal will likely cause a change in regulations so that a transfer using a 1031 exchange is deemed a “sale” because the underlying premise behind a like-kind exchange is that all profits from the previous real property investment are reinvested in another property.16 Moreover, the IRS will likely deem an exchange by a REIT that creates a capital gain beyond the $500,000 limit to be a “sale” counting towards the yearly seven sale limit. This effect will negatively impact commercial real estate markets because REITs will be further limited in their ability to be market participants. REITs help maintain and improve real estate valuations because they participant in numerous transactions. For example, in second quarter of 2021, REITs acquired $16.3 billion of commercial properties.17 Bearing the brunt of the impact is REIT shareholders, who will be negatively impacted because REITs will be limited in their ability to create the best cash generating portfolios.
Out of all of President Biden’s proposals that could impact real estate, this Proposal would have the most noticeable negative effects for several reasons. First, the Proposal is not efficient because it is an arbitrary cap, and the value will erode with higher inflation, limiting the usefulness of what would remain of the 1031 exchange.18 Second, it will discourage investment because it would subject the sale of a property to current rather than deferred taxation, “which could result in longer holding periods and less-productive deployment of capital in the economy.”19 Moreover, it will create a “lock-in” effect because capital gains taxation creates an incentive to hold assets for too long, and the “great majority of properties now swapped under the like-kind exchange would not be sold if tax was due.”20A lock-in effect occurs when an investor is unwilling or discouraged from selling an investment because of taxes or penalties associated with doing so. Last, it would likely raise less revenue because “[t]axes paid are 19-percent higher when a property is exchanged then sold versus never having been exchanged.”21.
Specifically, the Proposal will hurt individual real estate investors because individuals, not the super-rich, do most section 1031 exchanges.22 Furthermore, the Proposal will primarily affect multi-family and retail assets because those asset classes have historically represented 51 percent and 16 percent of all 1031 exchanges, respectively.23 Ironically, a savvy real estate investor can still avoid capital gains taxes under the Proposal. For example, one could sell assets that have achieved a capital gain above $500,000 before the Proposal would take effect and reinvest the proceeds using a 1031 exchange in multiple smaller transactions that would not result in a future capital gain over the $500,000 cap.
Fortunately, as of November 2021, this Proposal did not make it into the House Ways and Means Committee’s Responsibly Funding Our Priorities draft legislation and is unlikely to be adopted. See H. Com. on Ways and Means, Subtitle I – Responsibly Funding Our Priorities, https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SubtitleISxS.pdf (last visited Nov. 3, 2021); Northern Trust Corp., Likelihood of Proposed Tax Policy Changes, https://www.northerntrust.com/ntlanding/wm/institute/tax-policy-resource-center/index.html?utm_medium=digital&utm_source=dow+jones&utm_campaign=wm_grp-us-Navigate+Now-20211004&utm_content=WSJ_10+Point+Newsletter&utm_term=Tax+Policy+Resource+Center (last visited Oct. 13, 2021).)) Thus, the like-kind exchange and its benefits live to see another administration and congress.
The White House, Fact Sheet: The American Families Plan, 15 (Apr. 28, 2021), https://www.whitehouse.gov/wp-content/uploads/2021/04/American-Families-Plan-Fact-Sheet-FINAL.pdf. ↩
I.R.C. § 1031(a)(1). ↩
See I.R.C. § 1031(a)(3); IRS, Instructions for Form 8824 (2020) (Jan. 27, 2021), https://www.irs.gov/instructions/i8824. ↩
See IRS, Like-Kind Exchanges – Real Estate Tax Tips (Feb. 9, 2021), https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips. ↩
The White House, Fact Sheet: The American Families Plan, 15 (Apr. 28, 2021). ↩
See I.R.C. § 1(h)(D); I.R.C. § 1411. ↩
See Nicolas Bedo & Daniella Hale, August Rental Data: National Rent Growth Reaches Double Digits for the First Time, Realtor.com, https://www.realtor.com/research/august-2021-rent/ (last visited Nov. 3, 2021). ↩
Keith LeBlanc, The Biden Tax Proposals’ Impact on the Real Estate Industry, DGC (Aug. 13, 2021), https://www.dgccpa.com/perspectives/the-biden-tax-proposals-impact-on-the-real-estate-industry-1462. ↩
See I.R.C. § 857(b)(6)(c). ↩
I.R.C. § 857(b)(6)(c)(iii)(I). ↩
I.R.C. § 857 (b)(6)(a). ↩
Brian S. Masterson, Tucker on Tax Planning for Real Estate Transactions §10:11 (Thomson Reuters, 2021), citing Ltr. Rul. 200701008 (Sept. 29. 2006); Ltr. Rul. 200702021 (Oct. 3, 2006). ↩
See id. at §10:11 n. 11. ↩
The White House, Fact Sheet: The American Families Plan (Apr. 28, 2021). ↩
See Michelle Chapman, With Sale of the Venetian, Las Vegas Sands Exits the Strip, Associate Press (Mar. 3, 2021), https://apnews.com/article/venetian-casino-sold-las-vegas-645b6166fb6fa2b2fe7ce8925773345f. ↩
See generally I.R.C. § 1031(a)(1). ↩
See Calvin Schnure, REIT Property Acquisition Activity Heats Up, Nareit (Sept. 8, 2021), https://www.reit.com/news/blog/market-commentary/reit-property-acquisition-activity-heats. ↩
National Association of REALTORS, 1031 Like-Kind Exchange Myth Busters (Apr. 2021), https://narfocus.com/billdatabase/clientfiles/172/23/4372.pdf. ↩
See Leonard E. Burman, Indexing Capital Gains Could Both Reduce Lock-In and Harm the Economy, Tax Policy Center (Aug. 3, 2018), https://www.taxpolicycenter.org/taxvox/indexing-capital-gains-could-both-reduce-lock-and-harm-economy; Id. ↩
National Association of REALTORS ↩
See Will Parker, Biden Proposal Would Close Longtime Real-Estate Tax Loophole, Wall St. J. (Apr. 28, 2021), https://www.wsj.com/articles/biden-proposal-would-close-longtime-real-estate-tax-loophole-11619647044; Steven A. Marrer, Biden’s Tax Proposal to Limit IRS Section 1031 Exchanges, Kohrman Jackson & Krantz LLP (July 23, 2021), https://kjk.com/2021/07/23/bidens-tax-proposal-to-limit-irs-section-1031-exchanges/. ↩
See Marrer. ↩