The Tax Benefits of the 1031 Exchange
I'm sharing an opinion that is probably a little controversial in the real estate investing world, and it has to do with some recent government tax changes, real estate investing changes, all that good stuff. I've seen a lot of real estate and investing YouTubers here talking about this change, and I kind of disagree with most of them.
But what we're going to do today is, we're going to watch Graham Stephan's latest video talking about this change, and i'll share my thoughts as he kind of is explaining how everything is working.
Graham: So a few days ago, I made a video discussing my thoughts on the new personal tax increases along with an analysis of how that would affect the stock market.
However, I purposely left out one crucial point which has the power to completely change the landscape of real estate investing and home ownership, because honestly it deserves its own video.
And that brings us to today.
In the middle of one of the most heated housing markets of all time, a new tax proposal would limit one of the most popular real estate investing strategies out there, which currently allows you to buy and sell property without paying any capital gains tax in the process.
And for many people, that was the entire reason to buy real estate to begin with. But that might soon change.
This new proposal aims to end that, and in the process it might actually wind up increasing home values and making it even more difficult to find a place to live.
Not to mention, a new lending program might make home ownership even more affordable for more than two million Americans.
Lili: So before we get too far into this, I will say that in this video I'm gonna be responding to what I guess is the main quote-unquote controversy, and not necessarily how everything might affect the housing market because I'm not an expert on the housing market.
I'm not an economist, but I am going to share my opinion on the thing that most people are upset about, and that is not being able to basically buy zero dollar real estate. So let's get into it a little bit more before we talk about that.
Graham: So if you thought home ownership was competitive now, just wait because it might go from wild to crazy.
But before we go into that, two things: number one, I hope you understand that I do my best to be as unbiased, open-minded, and as neutral as possible, even though yes, real estate is still my largest investment.
Lili: So let's go back to the first point, and this isn't attacking Graham at all... but the idea that making home ownership more affordable, that it’s a bad thing, I disagree with.
Now, I think that there are going to be some repercussions. Right now, you have really low interest rates, and so that more people are bidding up on the housing supply that we do have, which is increasing prices.
And I think that I've actually heard Graham talk about some really good ways to get around making things more affordable and increasing prices drastically, because those two things coming together can be a drawback.
But I don't think that saying like, “Oh this new program is going to make two million more people able to buy and invest in real estate. Especially for homeowners themselves, to get out of renting, and that is in some way a bad thing."
Especially because you can see this top line here says, “This new program is aimed at lower income homeowners.”
Like a lot of times when we're having these conversations, it's people that are already rich and being like, “No, if you let the poor people in then, XYZ...” and I just disagree with that.
Anyway, back to the video.
Graham: Even though, yes, real estate is still my largest investment, and I've been a landlord now for over 10 years. That doesn't change the fact that we have to look at every aspect objectively, because as with anything there are going to be pros and cons that have to be taken into consideration.
The 1031 Exchange
All right, so first, to really understand the gravity of the situation and how these changes have the power to impact how people buy and sell real estate, we got to talk about what's known as the 1031 exchange.
This is a section of the tax code that allows you to buy an investment property and then sell and exchange it for another more expensive property in the future without being taxed on any of the profit in the process.
And yeah, if that sounds incredibly confusing, don't you worry I got you. And here's an example.
Let's just say you go and buy a two unit duplex for $500,000. Ten years later, that duplex is now worth a million dollars, and all of a sudden you want to use that profit to go and buy a larger, more expensive $2 million building instead.
Now ordinarily, if you were to go and sell that 2-unit duplex as is, you would have to pay a capital gains tax on that $500,000 worth a profit which means in a 20% tax bracket, you would have $400,000 left over to put towards that more expensive property.
However, if you qualify for a 1031 exchange, you would be able to sell that duplex for a million dollars, not pay any capital gains tax, and roll over the entire amount to the new, more expensive property where you could start the process all over again.
So now, let's say another ten years goes by, and that $2 million building is now worth $5 million.
Normally in a situation like this, if you were to sell at a profit you would have to pay a 20% capital gains tax. In that three million dollars worth of profit, which would be a loss of six hundred thousand dollars.
But a 1031 exchange would allow you to sell that property for five million dollars and use the entire amount to put towards the next purchase, which starts the process all over again.
Now technically, you're not avoiding tax, but instead you're deferring it in the future to the point where eventually, if you were to sell a 15 million dollar building that you traded up to, all of those taxes you deferred from the very beginning would be owed in one lump sum going all the way back to that first building.
The expectation here of doing this, is that by allowing you to exchange one investment property for another and deferring taxes in the process, it incentivizes you to consistently trade up to more expensive real estate.
It resets the property tax basis. Every time you buy something new, it increases inventory on the market.
The high transaction cost supplies money back into the economy through real estate agents, title companies, escrow companies, inspections, notary fees, and so on, and it prevents people from going and buying property and then holding on to it forever until they pass away.
So without going into all the specifics and making this concept more complicated than it needs to be, essentially real estate was a way for people to get some pretty substantial tax benefits, make money without paying any tax upfront, and long term, you could build your wealth incredibly quickly.
However, here's where we start getting into some of the downsides. Right now, the new tax proposal aims to abolish the 1031 exchange and limit the amount of money that you could defer into a new property by $500,000 per transaction, where anything over that would be treated as long-term capital gains.
See here's where things get pretty interesting. As it stands right now, you could 1031 as many properties as you want, with any amount, as often as you would like.
And the thinking is that eventually that final property is going to be sold, and at that point all the taxes are going to be paid. But, that might not be happening as often as they want.
Stepped-up tax basis
Well, that's because there's a part two of this 1031 saga where, when you pass away and your family inherits your real estate, there's something called a stepped-up tax basis that resets the taxes that they would owe to zero at the time of passing.
Let's just say for example, I've accumulated 20 million dollars worth of real estate throughout my lifetime with a 2 million dollar investment, and then when I turn 135 years old, I pass away and my family inherits my real estate.
Now normally, if I were to sell that property during my lifetime I would end up owing a capital gains tax on that $18 million dollars of the profit. But if I were to pass away and leave it to my family, their tax basis gets automatically reset to the market value of $20 million, and from there they'll only have to pay any capital gains tax on anything above that amount.
And this pretty much applies to any investment whatsoever.
Lili: Okay so first snaps to Graham, I think he did a really good job of explaining that.
And let's not be confused. This is a loophole in the tax code that benefits real estate investors.
And as Graham just showed, not just the everyday real estate investor, the house hacker, the wholesaler, the person with a few properties under their belt running a small rental portfolio.
This benefits the biggest of the big real estate investors. It benefits people who are buying multiple millions and millions of dollars worth of real estate. And allows us all, if we were to take advantage of this 1031 exchange, to get out of paying those capital gains taxes or basically to defer them.
And any real estate investor who's taken advantage of this that I've heard talk about it just plans on continuing to 1031 exchange property after property until they pass away. They'll pass those properties down to their family members, to their children.
Pretty much the expectation that I've heard most real estate investors talk about is that their kids won't owe any taxes at that point.
I'll get to the point of fairness in a moment, but first, it's a loophole that benefits the ultra rich. That's just a fact, and we can think about how even if you own your own house, you get certain tax benefits just by virtue of being a homeowner.
And if you were to be a renter, you would not get those same benefits.
When you pay your mortgage, that gets reported to the credit bureaus and helps improve your credit score. But when you pay your rent, most times that's not happening. There are some programs that are starting to allow that, but for the vast majority of people, paying your rent successfully and paying your cell phone bill successfully does not help your credit score.
Versus paying your mortgage, it does. There are all of these tax benefits, all of these legal and just social benefits to being a real estate owner and being a real estate investor.
And it's like yes, if you are able to take advantage of the 1031 exchange, then great.
But at the same time, like let's not pretend that it's not a loophole that's being closed up so that people don't make millions and millions of dollars like in this example Graham talked about and never have to pay taxes on it. Let's keep going.
Graham: And from there, they'll only have to pay any capital gains tax on anything above that amount.
And this pretty much applies to any investment whatsoever, whether it be art collectibles, stocks, bonds, real estate you name it.
And all of that could be stepped up completely tax free up to $23 million. However, under this new plan the stepped up tax basis would also be removed as a way to offset the cost of free community college for students.
Lili: All right, call me what you want, but I feel like just my own personal opinion, if I am making 20 something million dollars and paying no taxes, and part of that can be changed and taxed so that community college can be free for two years for folks, I'm probably willing to pay in my part.
I want I pay taxes so that we have so many things. I'm not opposed to paying taxes to be used for things that I believe in and that I'm in support of. That's just part of being a member of society, and I don't feel like this is the worst thing to happen, that multi billionaires are going to have to pay some taxes. What do you guys think right now?
Graham: The stepped up tax basis saves taxpayers about $41 billion a year, which is said to be money which could be more efficiently spent elsewhere. In addition to that, the inherited property would also immediately be taxed up front on the original tax basis, regardless of whether or not you wanted to sell.
And this would apply to anybody, whether you're passing down the next family house, or the next Mona Lisa. Now critics of this say that charging taxes up front might potentially force families to have to sell-off family heirlooms, real estate, and other property that's been held in the family for generations in order to come up with the tax bill. But proponents of this say that taxes should be paid up front because technically there's a transfer of ownership.
Lili: I get it, is it going to be inconvenient or difficult for certain people, mainly those with millions and millions of dollars worth of assets, be it real estate or whatever?
May this be an inconvenience or difficulty? Absolutely, but again, this is a loophole that's being closed.
Everyone else pays taxes up front. You get those taxes taken out of your paycheck. You get those taxes paid in the form of sales tax if you live in a state with sales tax. Everyone else pays taxes up front. This is closing a loophole for real estate investors to not have to pay taxes up front, to be able to defer them until they pass away, and then not burden their children with that tax bill.
It is a loophole, this is not a punishment. I think that's what's throwing me off.
There's a level of entitlement that I feel people have in that, “I am entitled to take advantage of this loophole.”
If the loophole is there, great. But the loophole being closed is not the same as being punished. It's just not.
Graham: Now that you got your low-cost index fund portfolio taken care of, here's what you came for.
The impact that this is going to have on the real estate market in 2015, a study was done which looked at the implications of the 1031 exchange in terms of how much they impacted the market. And the results were actually pretty surprising.
It was found that the 1031 exchange led to more liquidity on the markets because owners were incentivized to sell, and that helped stimulate job creation, investment, and economic growth.
Like I mentioned earlier, every single time a property is sold, about five percent of that property's value goes towards paying closing costs like paying agents, title companies, escrow companies, inspectors, notary fees, inspectors, insurance companies, and so on.
And in the process, all of them end up paying ordinary income taxes on the money they make.
Lili: Okay again, this is a loophole that benefits people who own real estate. Like that person who's selling that property doesn't have to pay the taxes on it, but everyone else who's getting paid from it does have to pay the income tax on it. So yeah, it is a loophole for the owners and for the ultra rich.
Graham: 88 percent of exchanged real estate was eventually disposed of in a taxable event resulting in substantially more tax being paid than what would have been due had the exchange not occurred. That's because the 1031 exchange incentivizes owners to keep reinvesting back into their properties and keep trading up to more and more expensive real estate. Whereas otherwise, they might just keep one property for life, do minimal repairs, and that's it.
In fact, when it comes to this it was found that taxable revenue was 19 percent higher than from a non-1031 exchange sale, largely because those owners spent more money on their property throughout ownership at a rate of 27 to 40 cents per square foot.
Not to mention, every single time a property is sold, the tax basis is reassessed at the new value. Meaning over time, property tax revenue goes up, and the more people buy and sell, the more revenue is generated. So the fear then becomes, “If the 1031 exchange is capped at $500,000, what's gonna happen?”
One argument would say that property owners would then be less incentivized to sell, and because of that less property tax revenue would be generated.
Property owners also might be less inclined to spend money fixing up their property because they don't need to maximize the value. And that, in turn, could lead to slower growth in landscaping, contracting, and so on.
It could also drive up the value of less expensive real estate because investors might be more inclined to get a 100% return on a million dollar sale that they bought for five hundred thousand dollars than a ten percent ROI and a five and a half million dollar property they bought for five million dollars.
If that happens and investors begin favoring smaller deals while competing with average home buyers, that could further dry up housing inventory and push prices even further into the stratosphere. So even though there might be some immediate benefits to getting rid of the 1031 exchange and collecting about 41 billion dollars more of tax revenue over the next four years, the net benefit could actually be significantly lower than that if people refuse to sell. That leads to lower taxes generated, and fewer jobs paid out in the process.
Lili: One thing I will say that I like about Graham's channel, is that he does a really good job of looking at things from all sides. And I think that the economists who are in charge of making these decisions should be doing the same. They should be looking at, what's the tax revenue that's going to be collected from ending the 1031 exchange, what are the effects that it could have immediately and in the future. But what I don't like and the whole reason I'm making this video is not to say the 1031 exchange is a horrible tax loophole or that it's a great strategy.
It's neither here nor there, because I'm not taking advantage of it right now anyway. But my point is that, the whining that I see happening because somebody is going to close the loophole, I just I don't get it.
I don't get it.
Graham: And if all of that happens, it could potentially take the real estate market from crazy to insane.
Now here's the thing. I rarely take an open stance on topics like this, and for the most part I prefer to give you the objective pros and cons of each and then let you come to your own conclusion.
But because real estate is something that I have worked full time in throughout the last 13 years, and it's how I built up my entire career, here are my honest thoughts and what I think is going to happen.
First, I think we should talk about removing the stepped-up tax basis. I'm actually in favor of putting some sort of limitations on this, and I think allowing investors to receive up to 23 million dollars completely tax-free is not exactly needed.
This just encourages investors to never sell anything throughout their lifetime, and that shouldn't have to be the basis of any investing strategy. However, taxing unrealized capital gains at the time of passing is going to put a lot of pressure on families to part with generational real estate, family heirlooms, and art just to pay for an upfront tax.
That would force them to pick and choose what they want to keep to be able to pay for it. Right now, the stepped up tax basis is intact because it would be a logistical nightmare to track down the tax basis of every single item added up, and then figure out and calculate how much tax is owed at the time someone passes away.
Like realistically, that would be pretty much impossible to calculate on items like art collectibles and stocks, which have been owned for decades.
So this current stepped up tax basis makes it all very easy to keep track of, and ensures that deca-millionaire fortunes end up paying some taxes.
But I think if there's a way the entire stepped up tax basis could be removed, then it just stays entirely the same at the time of passing, where the full tax would eventually be owed at whatever point they ended up selling it.
Then I would actually be all for it this. It would still allow you to pass down property, but the original tax basis would never change, and eventually when the property is sold, which is 88 percent of the time, the full tax would be paid with no stepped-up tax basis at all.
It would be like me going and buying that $2 million property, passing it on to family when it's worth 20 million dollars, and then whenever they decide to sell it, they would have to pay the full tax on that $18 million worth of profit.
And once you consider that most wealth is squandered after three generations, chances are at some point in the future there's going to be a pretty hefty tax bill. To me, that just seems like a very fair middle ground, considering that they're not going to force a sale. But they will collect the full amount of tax due whenever it does sell.
Now second, here are my thoughts when it comes to the 1031 exchange. I'm worried that even though it's really easy to look at this and say that removing it would end up saving 41 billion dollars over four years, what we don't know is how much money is actually going to be left over when you account for fewer properties sold, fewer property tax increases, fewer taxes paid by real estate professionals involved in the sale, and fewer improvements made to the property over its lifetime.
That alone could reverse all the tax revenue expected to be generated by removing the 1031 in the first place, and that needs to be taken into consideration. Now I do admit that right now it does encourage people to go and buy real estate, defer taxes indefinitely, and then die, so all the taxes are wiped out.
So removing the stepped up tax basis may somewhat help with this. So no taxes are outright avoided, but I think capping the limit at $500,000 would either disincentivize people from buying more expensive real estate or realistically owners would just decide to never sell the property and do a cash out refinance instead.
So they get all that money tax-free. I just suppose for me there doesn't seem like much of a benefit for getting rid of it when you consider that 88 percent of the time the properties are eventually sold and all the taxes are paid. Not to mention, a government survey found that the economy would be worse off by getting rid of it than keeping it intact.
All things considered, I say keep the 1031 exchange but get rid of the stepped up tax basis and allow the heirs to pay the full taxes owed whenever they decide to sell.
That way, taxes won't be completely eliminated but they can be deferred to the future and then paid in full whenever they decide to sell.
Not to mention, realistically we have no idea whether or not this is actually going to pass.
So it's certainly something to keep an eye on, and lastly here's the final story.
Like I mentioned earlier, 2 million homeowners could be eligible for a new mortgage program that would save them a substantial amount of money.
Now in order to qualify, you must have a mortgage backed by Fannie Mae or Freddie Mac, you must live in it as a primary residence, and you must have an income at or below 80 percent of the median income of your area.
If that's you, this new program would require lenders to reduce your mortgage payment by at least 50 dollars and a half a percent reduction to your interest rate.
Then after everything is said and done, it's estimated to save homeowners anywhere from twelve hundred to three thousand dollars a year.
To me, this just seems like a good way that low income households could get access to low interest rates. Whereas otherwise, they might not have known this existed or they might not have had the resources to go and refinance their house.
Lili: Great video from Graham.
I think this is an interesting topic, and it's something that I'm definitely going to dive into and learn a lot more about in terms of what some of the economic impacts could be.
But what I don't want is to have the perspective that if one thing changes not in my favor, then it means either that it's unfair or that real estate is no longer a good investment.
Benefits of Real Estate Investing
There's so many great reasons to invest in real estate, from the fact that your property value appreciates generally over time, that you can force it to appreciate by making improvements and updates, that you can get rental income, that there are so many tax benefits, even aside from something like the 1031 exchange.
Just for example, the deductions that you get every year come tax time on things like your interest, or insurance, or making upgrades and fixing things on your property.
There are so many reasons to invest in real estate, that even if the limit that the 1031 exchange can be used for is around half a million dollars, I think that there are still great reasons to invest in real estate.
And I think that there are some changes that need to be made to our current system and closing loopholes so that millions of dollars of taxes aren't deferred until someone passes away, and then wiped away and never paid.
I think it’s probably not the worst thing for us as a society.
I know it's probably a bit of a controversial take, but let me know what you think.
Until next time, thanks for reading.
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