How Biden’s New 1031 Exchange Rules Will Impact Real Estate

Biden’s New 1031 Exchange Rules and Biden’s new capital gains tax rates will have major impacts on money and investments for the foreseeable future.

First, Biden has proposed doubling the capital gains tax rate on high earners to almost 40%.

Second, Biden has proposed reducing the ability for investors to use the 1031 exchange in real estate.

This is a one-two punch for investors, homeowners, and the economy. It will undoubtedly have wide-ranging impacts on the value of investments for years to come.

But, how will Biden’s new capital gains taxes and Biden’s new 1031 exchange rules impact real estate?

What is a 1031 Exchange?

Before we dive into Biden’s new rules on 1031 exchanges, let’s do a quick refresh on 1031 exchanges. A 1031 exchange allows an investor to defer their capital gains on real estate earnings. This provides much-needed liquidity in the real estate market as you don’t have to take massive tax hits when selling one property to buy another.

Let’s say you purchase an investment property for $250,000 in Austin, TX 9 or 10 years ago, and now it is worth $1,000,000. Not an unrealistic situation at all as there’s been massive appreciation in that market.

You’ll be on the hook to pay taxes on $750,000 in capital gains, plus any depreciation you recapture. If you are taxed at the current 20% rate, you’d pay around $150,000 in taxes leaving you around $600k to invest in a new property.

Using a 1031 exchange, you could potentially use all $750,000 and invest it all into a new property, and defer the payment of those taxes.

I’m not going to dive much deeper into the 1031 exchange here. If you’d like a deep dive into the topic, check out our in-depth guide to 1031 exchanges here.

New 1031 Exchange Rules

The new rules limit the profits that can be deferred to $500,000 or less. While the exact rules have yet to be written, as far as most investors understand it, one could use a 1031 exchange to defer the taxes on the first $500,000 in capital gains but everything above that would be subject to capital gains taxes.

The New Capital Gains Rate Will Impact Real Estate, But How?

Biden has proposed increasing the capital gains rate from the current 20% on high earners to 39.6% on earnings over $1,000,000. This is nearly double the existing tax rate!

Let’s go back to the example above, if you sold the same $1m property and had to pay taxes on $750k in profits, your tax burden will now be an insane $297,000. You would be left with only $453,000 to invest in a new property instead of the $600k before. This dramatically impacts your ability to level up your investment portfolio.

Except for one pesky problem – the 1031 exchange. Real estate investors could have utilized the 1031 exchange in larger numbers to defer taxes and wait for a more investor-friendly administration to take power in the future.

While the higher capital gains rates would definitely impact the way real estate conducts business, the overall market most likely would not have been hugely impacted.

So, the Biden admin set their sights on us to make sure no market is left unscathed with their massive money grab.

How Capital Gains and New 1031 Rules Impact Real Estate

There’s a lot to unravel here so I’ll do my best.

First, there will be major short-term impacts. As capital gains for next year are expected to increase, people sell some of their investments to lock in taxes at the current rates.

This selling pressure is likely to stall the growth in markets or potentially cause declines. The level of decline is hard to predict as not all investors have over $1m in earnings, and those who do won’t sell everything.

With the original announcement of capital gains increases, I was very bullish for real estate as investors were likely to pile into real estate investments as there are far better tax benefits in real estate than in stocks.

Then came the new 1031 exchange rule for real estate.

How The 1031 Exchange Rules Will Impact Commercial Real Estate

As the 1031 exchange rules impact investors with gains over $500k, and the capital gains rates increases are supposed to be on those over $1m, we can predict that these changes will predominantly impact commercial real estate such as Multifamily, Self Storage, Mobile Home Parks, etc.

Going back to the example above, the first and most logical step is that anyone with the ability to sell in the short term will choose to sell now rather than pay taxes. The cost of waiting from December to January is a whopping 100% increase in tax burden!

Expect a short term surge in selling activity.

Not All Commercial Property Will Sell Immediately

We have to take one major factor into account – prepayment penalties.

Back from 2016-2019, almost all investors felt we were near the top of the housing cycle. Interest rates were rising and prices were flat.

As such, investors who purchased properties often opted for adjustable pre-payment penalty options such as Yield Maintenance. Additionally, many opted for 7 and 10-year terms instead of 5-year terms because they wanted to hold their properties through any turbulence in the market in the short term.

This is great if interest rates are increasing as your pre-payment penalty gets lower and lower.

But, interest rates went down instead of up. Many investors are stuck with massive pre-payment penalties. On top of it all, anyone with a 5 or 7-year term will have their loans come due right in the middle of this 1031 / capital gains fiasco.

This issue will accelerate over the next few years as more and more loans come due. They’ll be forced to either sell or lock-in longer-term financing. If rates are rising and values are decreasing it could create issues for refinancing. Inevitably some investors will choose to sell regardless.

The next question is where will that money go?

Money is fungible. It moves rapidly to new markets and assets and doesn’t look back with regret. So, now we have to think about the second level impact.

How the 1031 Exchange Rules Will Impact Residential Real Estate

There is one noticeable segment of the real estate market that will be entirely exempt from these new taxes – Anything with less than $500k in capital gains.

Logically speaking, these are assets with purchase prices under $1 or $2 million. The appreciation over a 5-10 year period is likely to be within the $500k limit.

Here’s the kicker – This is predominately in the residential 1-4 unit market.

As loans come due in CRE, it’s quite possible that many real estate investors will opt out of the larger commercial real estate and purchase portfolios of smaller assets which they can then sell piecemeal over a number of years.

This will put significant upward pressure on the single-family market and make housing even more unaffordable, limit the #1 wealth accumulation vehicle for individuals, and create many wide-ranging impacts we cannot predict.

Not All Investors Will Dump CRE and Buy Single Family

I want to point out that managing a single-family portfolio is far more involved than managing a multifamily property. So, not all investors will do this.

But, even if a few do make this switch, demand for single-family housing could increase 5-10% which would put even bigger constraints on an already very tight market.

So, How Will Bidens 1031 Exchange Rules Affect Real Estate?

There are thousands of variables to consider, so it’s impossible to know for certain. Assuming no new major changes come up after the time of writing, I believe:

• The economy will come back strong
• Inflation will shoot up rapidly
• The federal reserve will be forced to increase interest rates hard and heavy
• We will have to adjust to an inflationary environment for the first time in 4 decades.
• Cap rates on CRE go up. Investors try to find better tax havens and returns.
• Demand for single-family increases even though interest rates are going up. Investors will be cash-heavy with all the sales anyhow.

In summary, these tax laws may distort the market even further. The single-family bull market will continue. Commercial real estate including multifamily will take a breather.