Possible elimination of the 1031 exchange

By: J. David Chapman/March 21, 2024

J. David Chapman

The United States tax code allows real estate investors to defer paying taxes on the sale of a property as long as they reinvest the proceeds into another property. This tax rule, known as the “1031 exchange,” has been in place for over a century, dating back to 1921 during the presidency of Warren G. Harding.

Over time, there have been changes to the “like-kind” exchange rule, but it has largely remained intact. It is estimated that the annual 1031 exchange transaction volume exceeds $100 billion per year. However, President Biden’s new budget proposal includes a provision to eliminate this tax break.

According to the Biden Administration, “The Budget saves $19 billion by closing the ‘like-kind exchange’ loophole, a special tax subsidy for real estate. This loophole lets real estate investors – but not investors in any other asset – put off paying tax on profits from deals indefinitely as long as they keep investing in real estate. This amounts to an indefinite interest-free loan from the government. Real estate is the only asset that gets this sweetheart deal.”

I am not sure about the $19 billion in savings, but an impact study conducted by Ernst & Young in 2021, when the idea of ending 1031 exchanges was first proposed, found that these transactions support 568,000 jobs and generate approximately $7.8 billion in federal, state, and local taxes annually.

This proposed phase-out of the 1031 exchange will significantly impact the real estate market. If the exchanges are immediately eliminated, we could see many properties being held indefinitely to avoid paying taxes on the growth in value through multiple exchanges. If the program is phased out over time or given an end date, it would likely spark an uptick in transactions as investors rush to complete deals before the window closes. None of this will help an already reeling commercial real estate market embattled by rapid increases in interest rates.

Having participated in the 1031 exchanges and serviced clients who have as well, you would guess I would be a critic of the Biden proposal. You would be correct. Capping the 1031 exchange will have unintended consequences, including discouraging investment in real estate and potentially leading to a decline in property values. This provision has provided a powerful incentive for investors to reinvest in the sector, which supports job growth and economic development.

J. David Chapman is professor of finance and real estate at The University of Central Oklahoma (jchapman7@uco.edu)