Many real estate investors are wondering if the new 1031 exchange proposed changes will affect them. The answer is yes, and it affects some of them in a positive way while others may be negatively impacted. Let’s start by discussing what the 1031 exchange rule allows for property owners to do.
Under this rule, an investor can sell their investment property and transfer all profits into another like-kind investment property without paying any capital gains tax on the profit made from the sale of their previous asset. This is often done as a tax deferment strategy so that when they do eventually sell their second investment, they have not been taxed on any growth that has occurred between those two sales.
How Biden’s tax proposals could affect real estate investors
“The President’s tax agenda will not only reverse the biggest 2017 tax law giveaways but reform the tax code so that the wealthy have to play by the same rules as everyone else,” the White House said in a fact sheet describing the American Families Plan. “Importantly, these reforms will also rein in the ways that the tax code widens racial disparities in income and wealth.”
Biden has proposed raising taxes for people who make more than $1 million. The White House wants to also raise taxes on this group so it will go up from 20% to 39.6%.One of the changes includes ending the ability to raise the cost basis for real estate when it is inherited. This would mean that if you inherit property and later sell it, you have to calculate capital gains on what was originally paid for it rather than how much it’s worth at the time of inheritance.
The tax break for real estate investors, called Section 1031 exchange, allows owners to forgo paying capital gains and depreciation recapture taxes when the proceeds of selling a property are used to buy another property within 180 days. This tax break would be eliminated if capital gains were greater than $500,000 in the future.
Multifamily apartment investors may find the proposed changes for 1031 exchanges are very favorable.
But ironically this is a good thing for multifamily apartment investors. This may sound counter-intuitive at first glance but upon closer examination this may be a blessing in disguise.
We’ve always considered the 1031 exchange as a “kicking the can down the road” approach while building up the larger and large taxable amounts that will eventually need to be paid off. Thus as multifamily apartment investors, we typically frown upon this and instead embrace using bonus depreciation to reduce or eliminate that taxable gain upfront.
Eliminating the 1031 exchange will inhibit or eliminate a potential bidder who desires to swap properties in order to obtain one of a larger size and can always outbid us because their sole consideration is not paying taxes vs investor returns.
Encourage more migration out of the gateway cities
Moreover, some economists have projected an even larger out-migration from expensive coastal real estate markets than what is already happening. This will further improve the performance in our target investment markets.
The big picture
The proposed bill is a mixed bag for multifamily investors, depending on your investment philosophy.
What do you think about this new legislation? Let us know in the comments below!
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The Kitti Sisters