How elimination of 1031 exchange tax breaks could impact real estate investors

Real Estate | 10 Sep |

Real estate is one of Arizona’s most powerful economic drivers in Arizona. However, certain real estate investors could see a decline in profits and their income tax rate could increase if a plan Democratic Presidential nominee Joe Biden proposed is enacted.

Biden recently announced a $775 billion plan to boost Child and Elderly care. The decade-long plan will be paid for by reducing or eliminating 1031 tax breaks for real estate investors who make more than $400,000 a year. The new policy will put more emphasis on Cost Segregation Studies to reduce tax liability in the context of none or reduced 1031’s.

A 1031 exchange is a swap of one investment property for another that allows capital gains taxes to be deferred. If a real estate investor is considering a 1031, the properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred; if used correctly, there is no limit on how many times or how frequently 1031 exchanges can be done, and the rules can apply to a former primary residence under specific conditions.

Tempe-based RCG Valuation delivers cost segregation reports and teaches customers how to use their data and services to benefit their long-term real estate investment goals. Their team includes experts in cost segregation, thermal imaging, reserve studies and real estate consulting.

Scott Roelofs, CEO and owner of RCG Valuation.

Scott Roelofs, CEO and owner of RCG Valuation, said customers they work with tend to own commercial and multifamily properties. In the past, Roelofs said some cost segregation reports could cost thousands of dollars, and while working at another company doing cost segregation, he kept finding better methods to do it by adding technology, and after leaving that company established RCG Valuation in 2017.

“I always tell people real estate is Arizona’s industry,” Roelofs said. “So any changes to any real estate laws is going to dramatically affect Arizona. I’m from the Midwest; so when I talk to people from the Midwest, I say, ‘if you were going to sell your house, you would put it up for sale and never think about renting it,’ but in Arizona, everybody thinks about that, your first thought is, ‘should I sell this house or keep it and rent it and buy another house?’ and that’s the way we think here in Arizona, so that makes real estate the industry of Phoenix. The idea of buying houses at auction in other cities is a novelty; we have legitimate people who do that as their profession.”

Roelofs said if someone has a significant gain on a property they’ve purchased, they would use a 1031 exchange to not have to pay all the capital gains tax on it, which also depends on how significant the gains are. “Property and real estate is a very cash intensive business, you need money to buy the next property so you can’t have your money tied up in other areas. If you bought a building for $200K and now sell it for a $1 million, that’s an $800K gain, so all of a sudden you have a massive tax bill—really you want to roll that into the next property that’s going to generate your next growth, but now you’re getting hit with minimum $200K in tax.”

If Biden is elected and this policy is put in place, Roelofs said it’s likely investors will hold onto their property for a longer period of time, which could make it more challenging if they’re flipping any of those properties, which could result in lower profits, paying the ordinary income tax and their income tax rate could also go up.

If that’s the case, Roelofs said an investor’s decision could be, “‘I’m not selling this property’ but the effect of that would be ‘since I’m not selling this one, I’m not buying those other three,’ and then that changes how you would buy or sell a property because you go ‘I could buy this one and I’m not going to own this one after three months,’ but if that changes, now your timeline is a one-year timeline so it’s highly likely that it’s going to change the type of property that you buy.”

As a result, Roelofs said you could see a slowdown of business flow and some real estate investors could change their business model by buying a property, remodeling it, 1031 it and move onto the next property. In addition, multifamily properties could be affected because the flow of property sales is restricted.

“In many ways you’re affecting lenders, realtors, and others because the number of property sales made in the city would probably fall and we learned through 2008 that when real estate doesn’t work, there’s a lot of people who don’t work. If I’m flipping properties once a year and not every three months, business slows down for a lot of day laborers, contractors and general contractors and things start to change.”

In addition, Roelofs said typically a developer will build the property and sell it, but other developers purchase the property and often how that second party can afford that property is the sale of a different multifamily, so the “number of potential buyers goes down and high-growth areas are most affected. If a developer was saying 90 percent of their businesses were 1031 purchasers, then they have to make a different decision whether they’re going to develop or not,” Roelofs said.

“All of those things are going to affect all the decisions that are made because if your developer is talking to their sales team and asks if they have people lined up that are going to buy this, ‘how does the market look?’ And they say ‘they’re still buyers but it’s dried up significantly,’ maybe it doesn’t slow down the developer’s No. 1 property, but the 9th or 10th one—it’s those fringe properties that are potentially profitable, potentially not, or not as high of a priority that get shelved.”

As a result, Roelofs said if the number of buyers have declined, a developer could still move forward with a majority of the properties but wait on some of the ones that are lower priority. For example, if a developer was going to build a 200-unit apartment complex in a growing area, that impacts the potential growth for the entire neighborhood.

Show Buttons
Hide Buttons