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To learn more about how these work, you can read our guide to 1031 exchanges, but the general idea is that if you sell one investment property and use the sale proceeds to purchase another one, you can avoid paying capital gains tax on the sale.
For example, let's say you bought one investment property 10 years ago and own it free and clear with a $100,000 adjusted cost basis. If you sell it for $250,000, you would ordinarily have a $150,000 taxable gain, some of which would be considered depreciation recapture (taxable at a 25% rate) and some of which would be considered a capital gain (taxable at your capital gains tax rate). But if you were to use the proceeds to purchase another investment property for $250,000 or more, you can effectively transfer your cost basis to the new property. In short, your taxable gain doesn't just go away, but it wouldn't be taxable until you sell the new property.
Why could 1031 exchanges go away?
President Trump is a big supporter of tax breaks for real estate investors. But former Vice President Joe Biden, who is currently leading comfortably in the polls, is not.
Biden's tax plan has specifically called for eliminating tax breaks for real estate investors in order to pay for other provisions. And while it didn't specifically mention 1031 exchanges, it's the most likely real estate tax break to be on the chopping block, simply because of the amount of money that's passed through to other properties on an annual basis. Indeed, 1031 exchanges account for 6% of all commercial real estate sales volume and cost the government $2 billion to $4 billion in lost tax revenue per year, according to a study by the University of Florida and Syracuse University's Whitman School of Management.
1031 exchanges are only a part of the plan
Not only could Biden's plan eliminate 1031 exchanges, but it would also raise capital gains taxes on high earners. Specifically, the plan would get high earners to pay more by "asking those making more than $1 million to pay the same rate on investment income that they do on their wages," says the Joe Biden website.
To put it mildly, this could be a big deal. The current maximum capital gains tax rate is 20%, and it only jumps up to 23.8% with the net investment income tax that high earners have to pay. But Biden wants to raise the top income tax bracket to 39.6% (currently 37%), so capital gains taxes could nearly double for high-income real estate investors.
What would this mean for real estate investing?
The short answer is that if 1031 exchanges are eliminated, it would make real estate investors think twice before selling investment properties -- especially true if higher-income investors end up having to treat capital gains as ordinary income.
To be clear, I'm not trying to be political here; I'm not opposed to or in favor of Biden's tax plan. But if it's ultimately signed into law as currently written, it could take away one of the main incentives for real estate investors to not only put their appreciated investment properties on the market but to use the proceeds to buy another one.
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