Joe Biden and his campaign have proposed eliminating the 1031 exchange for real estate investors that make over $400,000 per year. The extra capital gains tax from eliminating this exchange would be a major part of funding Biden’s proposed a 10 year $775 billion plan focused on improving child care and care for the elderly.
Biden is not the first politician that has proposed eliminating the 1031 exchange. While many politicians have proposed closing this exchange, finalizing this idea has not yet occurred because many lawmakers recognize the positive impact 1031 exchanges have on individual investors and the economy as a whole. Many experts have already discussed that if Biden would remove the 1031 exchange, it could—combined with the economic effects COVID-19—collapse the real estate market. Further, removing the 1031 exchange would hurt small individual investors much more than the real estate tycoons Biden is targeting. The reason for this is that the 1031 exchange allows people to own real estate with less debt and has been shown to disproportionally help minority and women investors.
Though it would be devastating to the economy if Biden would remove this exchange, below is a general overview of 1031 exchanges and alternative financial tools that real estate investors can use if Biden does terminate 1031 exchanges.
What is a 1031 Exchange
The 1031 exchange refers to a section of the Internal Revenue Code that was conceived of in 1954 as an amendment to Section 112(b)(1) of the tax code. While the reach of the 1031 exchange has changed since its original inception, the main benefits of this exchange have remained the same. A 1031 exchange allows like-kind property—including both real and personal property—to be exchanged on a tax-deferred basis under certain circumstances. This exchange first encompassed assets such as securities, real estate, franchises, collectible art, and other assets. However, after the 2017 Tax Cuts and Jobs Act passed, the only category of property that was covered was real estate.
In general, there are two main benefits to utilizing a 1031 exchange. The first advantage is that when using this exchange, you are able to defer capital gains tax. The second advantage to using this exchange is that one can grow a real estate portfolio with a small investment.
1031 Exchange Alternatives
If Biden does remove the 1031 exchange, there are a few alternative financial tools that investors can utilize. For example, real estate is an allowable investment in both IRAs and 401(k) plans. Both of these accounts defer taxes. Thus, these accounts allow real estate investors to not worry about high tax bills should Biden follow through with eliminating the 1031 exchange. Even if Biden does not eliminate the 1031 exchange, these alternative accounts offer benefits as they do not require an investor within the 45-day window.
For individuals that invest, retirement savings commonly represent the largest pool of investable assets. However, only 2 percent of IRAs hold alternative investments like real estate. Thus, when considering alternatives to 1031 exchanges, consider using IRAs for some of the same benefits.
Why Use an IRA
IRAs and 401(k)s have been a staple in investment accounts ever since the 1970’s. Since its inception, millions of Americans in every income bracket have utilized these retirement accounts because of their tax advantages. Because of the widespread use and other benefits to investors, Biden is unlikely to terminate IRAs and 401(k)s. In fact, the opposite is likely to occur. Biden may even increase the number of people who can contribute to these types of accounts.
The main benefit to an IRA or 401(k) for real estate is that any rental income you receive grows tax-deferred. Thus, you can accelerate returns and quickly re-invest this money to increase growth.
When a Retirement Account is not Appropriate
Depending on an individual’s circumstances, placing a real estate investment in a retirement account may not make sense. For example, if you place a property in an IRA account, you cannot improve or work on this property yourself. Another case where cannot utilize an IRA or 401(k) if you are going to rent the property to family members. The reason for this is that renting a real property to your family member violates retirement account rules. Further, and if broken could lead you to incur financial penalties.
Final Thoughts
Leveraging the 1031 exchange can be a great way to build wealth. The ability to defer capital gains tax on an unlimited number of property sales allows you to build generational wealth.
However, it is imperative that you understand the alternatives to the 1031 exchange in case Biden terminates this financial tool. Though IRAs and 401(k)s may offer you alternatives, you must ensure that they work for you. With over twenty years of experience, the real estate attorneys at Antonoplos & Associates have to knowledge and experience required to assist with a myriad of real estate issues in DC, Maryland, and Virginia.
Contact Our DC Law Office for More Information
Finally, for more information on Biden’s tax plan threatens to do away with the 1031 exchange, contact us at 202-803-5676. You can also directly schedule a consultation with one of our skilled attorneys. Additionally, for general information regarding real estate law, check out our blog.