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The 1031 Exchange Cap Debate

In the current political landscape, the age-old tug of war between liberals and conservatives is as tense as ever. The urge to dismantle what is perceived to be a tool solely for the rich is truly misguided. In place for over 100 years, the Internal Revenue Code Section 1031, is a valuable tool to defer capital gains taxes on income real estate, and it benefits landowners directly, and many other people indirectly. Currently, there is no limit on the amount of gain to be deferred. The Biden administration has proposed capping the lifetime gain to $500,000 of capital, to help fund the $1.8 trillion American Families Plan, released in April and still under review.

The proposed change would generate $2 billion per year for the treasury, amounting to 0.001% of the total cost of the bill. What is not mentioned is the loss of tax revenue that would ensue after the change goes into effect. One of the most respected accounting firms in the country, Ernst & Young, estimates 1031 exchanges generate more than $5 billion in federal tax revenue per year and billions more in state and local taxes.

It’s not just a tax revenue shell game being played here. The bill would have a sweeping effect on the entire real estate industry, hurting many sectors, and many people who are not rich, and not commercial property owners. The program stimulates the movement of capital to invest in many underserved communities. If a commercial property owner must pay the capital gain of 20% after reaching the cap of $500,000, many would not sell in the first place, as the tax would dramatically inhibit a decision to sell, and provide less capital to invest in a future project. Such a dynamic has the unknown risk of actually stifling tax federal revenues as well.

In recent studies by Syracuse University and the University of Florida, like-kind 1031 exchanges stimulated greater capital investment in properties using the tax provision compared to those that didn’t use it. Bill Brown, owner of Springhill Real Estate Partners said “Every time we sell an apartment complex, we use the 1031; if it were not available, we would not be able to complete that transaction.” His company’s investments in new projects provide jobs, and revenue for material providers such as carpet, cabinets, plumbing, electrical, roofing, siding, etc.

The President has touted “jobs, jobs, jobs” as his mantra for bringing the economy back. Research clearly shows that like-kind exchanges have a multiplier effect in creating jobs in a community. According to the Ernst & Young study, if the 1031 exchange were limited as proposed, real estate transactions would decrease, causing a contraction of the gross domestic product. As it stands now, $4.4 billion of investments and 568,000 jobs are supported each year under the program, generating $27.5 billion in labor income in 2020. “The like-king exchange is a great tool to create jobs for our members,” states Frank Furco of a local electrical contractor’s union in Illinois.

The ripple effect of the 1031 investment tool directly impacts real estate investment trusts (REITs), and the pension plans that invest in them. It can also serve a different purpose—the preservation of open space. Land conservation organizations rely on 1031s, often to exchange environmentally sensitive areas for less sensitive ones. These entities have used it to enable the creation of a wide range of conservation lands nationwide. A $500,000 cap on the gain deferred would impact this activity considerably.

It is clear, therefore, that a cap on the 1031 exchange program would have a deleterious effect on the economy, and on working peoples’ livelihoods—the very thing this President wishes to preserve and stimulate.

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