President Joe Biden has proposed capping Section 1031 “Like-kind exchanges” as part of a multi-part “infrastructure” spending plan that raises taxes by $3.5 trillion. Biden would disallow taxpayers from utilizing 1031s if they had gains exceeding $500,000.
This tax hike is misguided and should be rejected. 1031s are not a tax loophole as some claim but are important tax provisions promoting reinvestment and liquidity. Repealing this provision would harm smaller real estate investors by forcing them to forego new investments or go into debt to finance transactions. It would also fail to raise significant revenue and is almost useless as a “pay-for” for the Biden spending plan.
What are 1031s?
1031s promote investment in residential and non-residential property by allowing taxpayers to defer taxes on their capital gains if they reinvest these earnings in a new property.
Section 1031 has existed in the tax code for 100 years. It allows investors to defer paying taxes on the sale of real property if they reinvest the earnings into a substantially similar asset. This can be done, again and again, provided the transaction involves a similar type of property.
Because investors don’t have to pay tax until they cash out, Section 1031 eliminates a potential barrier to investment, which in turn promotes the more efficient allocation of capital resources.
For many years, 1031s were widely used for assets including real estate, machinery for farming and mining, and equipment such as trucks and cars.
As of the 2017 Tax Cuts and Jobs Act, like-kind exchanges can only be used for real property. Other assets are no longer eligible because they instead qualify for “full business expensing,” which incentivizes capital expenditure by allowing businesses to deduct the cost of new investments immediately.
However, Congress affirmatively retained like-kind exchanges for real estate in acknowledging the importance of Section 1031 as a provision to incentivize capital formation and investment in property.
1031s are not a tax loophole
Critics of 1031s often falsely allege that they are a loophole that allows taxpayers to avoid taxes. This is not true because the provision defers rather than eliminates tax liability. A taxpayer that utilizes Section 1031 will eventually pay taxes on the asset when they cash out.
In many cases, the tax deferral period is shorter than many assume because taxpayers do not utilize 1031s indefinitely. As noted in a study conducted by David C. Ling and Milena Petrova, the vast majority of 1031 acquired assets are later disposed of in a taxable sale:
“In contrast to the common view that replacement properties in an exchange are frequently disposed of in a subsequent exchange to potentially avoid capital gain and depreciation tax liability indefinitely, we find that in 88 percent of the cases in our dataset, investors dispose of properties acquired in a 1031 exchange through a taxable sale.”
How do 1031s benefit the economy?
There are significant benefits to the tax deferral offered by 1031s.
Recent studies have found that 1031s help provide taxpayers with liquidity that they can use to invest and create jobs. For instance, a study conducted by EY found that 1031s contribute $55.3 billion in GDP in 2021 and support 568,000 jobs and $27.5 billion of labor income.
By providing additional liquidity, 1031s allows investors to avoid taking on debt and becoming over-leveraged. This also helps with the financing of new real estate projects, promoting a competitive and affordable housing market.
1031s are typically used for smaller real estate transactions. According to the National Association of Realtors, 1031s were used in about 12 percent of real estate sales. Almost 85 percent of these transactions were from smaller investors such as sole proprietorships or S corporations.
Repealing 1031s would harm investment in property. It would increase holding periods as taxpayers would be encouraged to retain assets longer to avoid paying capital gains taxes.
In fact, due to the added complexities of financing projects and taking on debt, an estimated 40 percent of real estate transactions would not have occurred without 1031s.
Repealing 1031 raises very little revenue
In addition to having significant negative economic impacts, repealing 1031s would raise very little revenue.
During the presidential campaign, Biden called for using revenue raised from repealing 1031s to finance $775 billion in new spending on childcare and elder care over the next decade. However, repeal of 1031s does not come close to paying for the total cost of this new spending.
According to the Joint Committee on Taxation’s tax expenditure report, like-kind exchanges reduce revenue by $51 billion over five years.
However, this number should not be confused with the amount of revenue that would be gained from repealing the provision. As the JCT notes, tax expenditure calculations should not be confused for revenue estimates, in part because they fail to account for behavioral changes:
“A tax expenditure calculation is not the same as a revenue estimate for the repeal of the tax expenditure provision…unlike revenue estimates, tax expenditure calculations do not incorporate the effects of the behavioral changes that are anticipated to occur in response to the repeal of a tax expenditure provision.”
Before the TCJA narrowed 1031s to real estate, the JCT estimated that this tax expenditure was $98.6 billion over five years. In contrast, revenue raised from repealing 1031s was just $9.3 billion over five years, just 10 percent of tax expenditure value.
This significant difference is due to the fact that repealing like-kind exchanges would significantly alter the behavior of taxpayers leading them to forego new investments, which would reduce future taxes paid when the asset is sold, and reduce revenues from higher wages and more jobs created by 1031s.
Extrapolating this number based on today’s tax expenditure estimate would suggest that the score of repealing 1031s currently would be just $5 to $6 billion over five years. Extending this estimate further to the ten-year window would suggest revenue raised of just $10 to $12 billion – a fraction of the of Biden’s $775 billion in new spending.