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Should 1031 Exchanges Be Limited?

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The Biden administration has proposed implementing limits on the Section 1031 exchange program that gives real estate investors the opportunity to defer payment of capital gains taxes on like-kind exchanges of real property.

Under the proposal, the amount of capital gains tax that could be deferred under the Section 1031 program would be capped at $500,000 for individual filers and $1 million for joint returns.

Democrats have also proposed raising the capital gains tax above those thresholds from 23.8% to 43.4%. Currently, taxpayers can defer an unlimited amount of capital gains tax if they exchange qualifying real property for another qualifying real property asset.

We asked two professors and authors of ALM’s Tax Facts with opposing political viewpoints to share their opinions about capping the Section 1031 deferral amount.

Below is a summary of the debate that ensued between the two professors.

Their Votes:

Bloink

Byrnes

Their Reasons:

Bloink: Capping the amount that can be deferred under Section 1031 at $500,000 for single filers and $1 million for joint returns makes complete sense. When ordinary taxpayers sell their primary residence, which is usually their most valuable capital asset, their tax-free deferred gain is limited to $250,000 for single filers and $500,000 for joint returns. Why should super-wealthy taxpayers who have the resources to manipulate the tax system benefit from an unlimited deferral?

Byrnes: Capping the 1031 deferral amount would cause negative consequences that the Biden administration obviously hasn’t fully considered. These proposed limits would make real estate investment significantly less attractive at a time where the commercial real estate market is still reeling in the wake of the COVID-19 pandemic — endangering the jobs of countless Americans whose positions depend on a robust commercial real estate market.

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Bloink: These deals almost exclusively benefit wealthy real estate investors since the 2017 tax reform legislation limited Section 1031 to exchanges of real property. We have to find a way to pay for the vast expenditures made during the pandemic, and this seems like a fair deal.

Byrnes: Many of the buildings that are the subject of 1031 exchanges are smaller residential properties. If those deals are canceled because investors aren’t receiving the tax benefits they’re expecting, that’s only going to put even more pressure on housing prices — which are already at historical highs. Limiting the tax benefits would also mean investors who already own these properties no longer have an incentive to make improvements to the property.

So, when you think about it, who really suffers if we cap the 1031 program? Ordinary taxpayers who are struggling to find affordable rental housing in an already challenging market.

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Bloink: This proposal plans to limit only the amounts that can be deferred under Section 1031. If enacted, the new plan would allow these real estate investors to continue to recognize some tax benefits to exchanging real property. No other asset receives the benefit of tax-free exchange treatment. Logically, real estate investment would, therefore, continue to be one of the most attractive investment opportunities for individuals who already hold real property investments.

Byrnes: We’re talking about a plan that would stifle the economy at a time when people are just starting to get back on their feet again. Real estate sales volume would be dramatically reduced if taxpayers aren’t able to realize the full benefits of the 1031 exchange program. This is a misguided approach that might generate a nominal amount of revenue, but would really serve only to encourage real estate investors to simply hold on to their real property investments and wait for the next change in leadership — eliminating jobs and hurting the housing market in the process.

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