How Biden’s real estate tax plan may hit smaller property investors

Real estate investors may soon pay more taxes on high-dollar transactions.

President Joe Biden is asking for higher taxes on real estate transactions with gains of more than $500,000. The tax plan aims to help cover the $1.8 trillion American Families Plan, which pumps money into child care, paid family leave and education programs.  

However, financial experts say the tax hike may also put a strain on smaller investors.

The strategy on the chopping block — so-called like-kind or 1031 exchanges — allows investors to defer paying taxes on real estate by rolling profits into their next property. 

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“You don’t have to take a haircut for Uncle Sam’s share every time you move from one investment to another,” said Michael Repak, vice president and senior estate planner at Janney Montgomery Scott in Philadelphia. 

Currently, investors can use 1031 exchanges to buy and sell tax-deferred real estate throughout life. If the investor holds the property until death, they can pass it on to heirs tax-free.  

“This has been a great way for real estate investors to make money,” said Matt Berquist, a Jacksonville, Florida-based certified financial planner and managing director at Intrepid Capital Management.

The congressional Joint Committee on Taxation estimated that 1031 exchanges may save investors $41.4 billion in taxes from 2020 to 2024. 

Biden aims to reel in 1031 exchanges on transactions with profits exceeding $500,000.  

The effects may be far-reaching, financial experts say, especially with the call for an increase in capital gains taxes.

About 12% of real estate sales were part of a 1031 exchange from 2016 to 2019, according to a 2020 survey from the National Association of Realtors. 

Those investors may not be the real estate tycoons many expect.

Although Biden’s plan targets the wealthy, the proposal may also hit smaller investors.

The Realtors survey showed 84% of 1031 exchanges were by smaller investors — those in sole proprietorships (47%) or S corporations (37%).

“There will be some unintended consequences if it all goes through,” Berquist said.

Small businesses looking to exchange property may face some tough decisions. 

For example, let’s say a dental practice owns a $1.2 million building it had originally purchased for $500,000. Under current law, the owners can exchange the property for a “like-kind” office building and defer taxes by adding the $700,000 profit into a new building they’ve bought. 

The new law would charge capital gains taxes on the company’s profit above the $500,000 exemption.

Repak said the new rule could make it difficult for those looking to exchange for a lower-maintenance property as they move into retirement.

The proposed changes may also trickle down to small businesses renting property. 

Sixty-eight percent of those surveyed by the Realtors expect rent increases if 1031 exchange repeals occur.     

Repak said landlords may try to recoup losses or extra taxes by charging more rent.    

“Renters are probably the easiest to try and push that onto,” he said.  

While details are still murky, Repak said some investors are starting to prepare for changes. He said it’s prudent to begin talking with your estate planning attorney and accountant.

Those impacted shouldn’t make an impulsive decision, however.  

“There are all kinds of things on the docket that could change for folks,” Berquist said. “People need to be ready and open to making changes as necessary.”