The ability of President Joe Biden to pass sweeping economic reform hinges on his ability to increase tax revenue. President Biden has stated he will increase revenue by closing tax loopholes for wealthy Americans. Many of the “loopholes” President Biden seeks to close could significantly affect the real estate industry.
President Biden’s proposed tax plan considers ending two very important and longstanding benefits to real estate investors:
- Elimination of tax deferrals from a 1031 exchange of property
- Elimination of the $25,000 exemption from the passive loss rules for rental real estate
1031 Exchanges
Section 1031 of the Internal Revenue Code was first enacted as part of The Revenue Act of 1921 and, after adjustments in the 1950s and 1980s tax reforms, reached its final present day form via the Department of the Treasury rules and regulations effective July 2, 1990.
The main advantages for owners/operators in commercial real estate markets are deferring tax liabilities and increasing the investment capital available to invest in similar or larger projects. In 2019, the Joint Committee on Taxation (JCT) estimated a $9.9 billion tax revenue loss because of commercial real estate like-kind exchanges. The JCT estimates this loss will accumulate to $51 billion during 2019 to 2023. [1]
President Biden seeks to repeal Section 1031 exchanges to reduce the estimated $9.9 billion loss. [2] The deferral of tax liabilities into the unforeseen future places an extreme strain on revenue for federal and state governments already strapped for cash. COVID has only increased the deficit of state governments with reductions in sales tax revenue. The repeal of Section 1031 exchanges would undoubtedly increase tax revenue for federal and state governments initially, but it could also adversely affect the same in future years.
There are a number of adverse consequences to a repeal of Section 1031 exchanges, including a decrease in reinvestment in commercial and residential real estate, greater use of leverage, downward pressure on employment (especially in related sectors) and decreased benefits for local governments.
A study by Ling & Petrova [3] confirms the negative trickle-down effects to multiple construction and real estate markets. Some key findings from the report:
- Real estate values would drop;
- The cost of capital would increase;
- Average holding periods would increase;
- The velocity of investment in the economy will decrease;
- Rents will rise; and
- The economy will contract.
Commercial and residential owners looking to dispose of a property in the near future should closely monitor President Biden’s tax policies. Without Section 1031 tax advantages, capital expenditures for the next property may be substantially less.
$25,000 Passive Loss on Real Estate Rental
If an individual is not a real estate professional, a special rule allows the investor to categorize as much as $25,000 of rental losses as nonpassive losses. This means the individual can deduct up to $25,000 of rental losses from nonpassive income, such as salary, dividends and interest, but this treatment completely phases out when the investor’s modified adjusted gross income reaches $150,000.
To qualify for the special allowance, the investor must (a) actively participate in the operations of the rental property at all relevant times and (b) own at least 10% of the value of all interests in the activity throughout the year.
If this special deduction were revoked, it could reduce an investor’s available cash flow and therefore the ability to purchase additional real estate. The nondeductible losses would continue to accumulate as passive loss carryforwards until the rental property produces income or is sold.
Conclusion
President Biden’s repeal of Section 1031 exchanges and the $25,000 passive loss allowance could be harmful to the real estate industry and conflicts with some of the stated goals of tax reform. These so called “loopholes” are the essential incentives that stimulate transactional activity for a healthy and strong real estate market.
Author: Daniel P. Collins, JD, LLM, Real Estate Team Member | [email protected]
Withum real estate team member for further assistance.
Real Estate Services
[1] The JCT provides estimates of “tax expenditures,” which are defined under the Congressional Budget and Impoundment Control Act of 1974 (the “Budget Act”) as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption or deduction from gross income or which provide a special credit, a preferential rate of tax or a deferral of tax liability.” Thus, tax expenditures include any reductions in income tax liabilities that result from special tax provisions or regulations that provide tax benefits to taxpayers
[2] The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate, September 2020
[3]Id
