Real estate, politics, and taxes. Besides death, these are three certainties in life, so it’s important to watch a critical real estate tax benefit that’s politically in play right now—if it goes away, investing in homes becomes much less attractive.
The WSJ reports the tax deferred exchange, known as the 1031 Exchange because of the IRS code it’s associated with, is at risk of extinction as lawmakers wrestle with tax reform in Washington. This is a far reaching tax break that tends to be associated with commercial real estate, but it has huge influence on residential real estate too.
It works like this: when you invest in stock you have capital gains and those gains are taxed after you sell the stock. Same goes for buying property you don’t live in. The price of that property (hopefully) goes up and when you sell the property, you’re taxed on that gain. But the 1031 allows you to defer that gain if you reinvest all proceeds from your sale into a new property at a purchase price equal or higher than you sold for as long as you identify new property within 45 days of closing your sale, and close the new purchase within 180 days of the sale.
Home investors who do these exchanges have their down payment on the new property built in (the proceeds from the sale), and they don’t pay taxes on the gains from the sale. And the good investors do these tax deferred exchanges over and over to remain tax efficient long term.
When entrepreneurial gurus say “real estate is the best way to build wealth in America!” that’s code for “the 1031 Exchange is the secret to growing your investments without the tax hits!” But the latter statement just doesn’t look right on that Learning Annex flier stapled to a telephone pole near you.
Even though you can’t just pocket tax free gains when selling an investment home (because you must reinvest your sale proceeds into a new home to defer the taxes) home investors obtain cash they might need by borrowing equity out of the new home. Smart home investors keep deferring taxable gains by reinvesting in new properties long term and accessing cash as needed via home financing.
If rates spiked this wouldn’t work as well, but rates have been extremely low for almost 10 years, and with no strong signs that inflation will spike, it looks like rates won’t rise dramatically anytime soon.
This isn’t to suggest you should rush over to your neighborhood “Build Wealth As A Landlord” seminar, but there’s absolute truth to building wealth with real estate, and the 1031 Exchange is a big reason it all works.
So will this tax break survive?
The good news is that the 1031 Exchange exists today and has survived since 1921, and with a real estate investor running the White House, let’s hope lawmakers wise up and keep this tax break.
There’s often flare ups in Washington about killing another beloved tax break that allows people to deduct the mortgage interest they pay on their primary residences, then it dies down and the tax break stays. For now, the same thing seems likely with the 1031, and I predict this tax break will survive for two main reasons:
1. Killing the 1031 would crush the commercial market. Commercial property owners and developers use the 1031 exchange to avoid massive tax hits when choosing their next projects. If they had to take those hits, owners might not sell at all, and developers won’t be as fast to move into new projects. The timing requirements of identifying a new investment within 45 days of selling the old investment keeps capital moving into new projects more quickly.
2. Killing the 1031 would slow investment in the residential rental market. In high priced regions, more people live in the homes they own, so not having a 1031 exchange option is irrelevant because it only applies to rental homes. With Wall Street increasingly buying up rental homes, the allure of the 1031 exchange is certainly a factor, and not having this option would make rental buying less attractive and could drive down transaction volume. And when there’s less home transaction volume, municipalities lose out on critical property and transfer tax revenues.
Maybe the Federal lawmakers don’t care about local tax revenues. Or maybe the 1031 will go away in this new era where political norms are shattered on a daily basis. But until the 1031 is gone, it’s law, and the rest is chatter. Those who understand it or learn to understand it can do very well in real estate.
– Infographic from 1031 Exchange company Income Property Advisors
– I want to thank my friend Ian Bunje from Independent Exchange Services for sharing his thoughts on this matter with me. He’s been a great advisor to me and countless clients over the years on 1031 matters.