The proposed changes to the 1031 exchange will create significant burdens for small local investors.

The 1031 exchange has been around since 1921. It has been a point of contention across political lines for decades, but now it seems President Biden will take a decisive step to change the path of this tax law.

The popular tax break, also known as a “like-kind exchange,” allows real estate investors who have owned a property for at least two years to defer their capital gains taxes when they invest their profits from a real estate sale into buying another property within 180 days. In other words, it allows real estate owners the ability to make optimal decisions about whether to keep or sell their assets, without negative tax consequences.

President Biden plans to eliminate 1031 exchanges on transactions where the capital gains exceed $500,000. Support for the proposal hinges on the idea that this will only impact wealthy investors (i.e., the 1% who can easily afford it). While this may be great sounding PR to sell to the American public, this is far from the case.

Rather than being a tax loophole, like-kind exchanges serve as a catalyst of economic activity. They support small scale investors and small businesses too. The proposed changes will negatively affect real estate in a variety of ways.

1. Won’t Impact Wealthy  Investors Only

According to the National Association of Realtors survey from 2020, 1031 exchanges were used in 12% of real estate transactions between 2016 to 2019. And if we dig a little deeper into this survey, we see that 84% of these 1031 exchanges were used by small investors (defined as sole proprietorships or S corporations).

The proposed change to 1031 exchanges intersects with the recent restructuring we’ve been seeing among multifamily and single-family rental property ownership moving more toward larger institutional investors. The trend toward larger investors is being driven by several factors. Most notable is the lack of support offered to landlords since the onset of the eviction moratorium, which is pushing many small landlords to sell. A National Rental Home Council survey conducted earlier this year revealed 23% of small landlords said they plan to sell at least one property due to that factor.

Institutional investors, meanwhile, have been continuing their play of buying up hundreds of thousands of rentals en masse. According to Redfin, $77 billion of institutional capital made its way into acquiring residential rental properties during the first half of 2021 alone.

The existing 1031 exchange rules provide much-needed financial benefits for many small investors. However, the Biden administration’s proposed changes to the 1031 exchange may have negative consequences on small local investors, including making it more difficult for smaller investors to acquire larger assets using a 1031 exchange. As a result, larger assets may be pushed into the hands of institutional owners.

A well-functioning market depends on a healthy mix of investors of all sizes. Government policy that makes it harder for the little guy to compete and pushes more profits outside of local communities skews that mix.

2. Increased Financial Burden on Small Businesses

Among the statistics on 1031 exchanges quoted above, you will find independent small businesses that own their commercial premises and have benefited from the tax break when relocating to new premises. This includes small businesses such as barber shops, grocery stores and accounting firms—mainstays of local neighborhoods. The current 1031 exchange encourages such small businesses to expand by offering them tax incentives when they purchase a larger facility.

In fact, the 1031 exchange can be a lifeline for many small businesses that must relocate or want to expand and trade up for a larger facility

Under the new proposal, however, plenty of small businesses would lose a significant chunk of these tax incentives. Although $500,000 sounds like a high threshold, plenty of commercial properties that have been in the hands of small family businesses for decades will easily exceed this $500,000 amount. In other words, the proposed tax reforms may significantly impact small businesses.

It’s not only small businesses that own their commercial properties that could be impacted by the proposed change. Small businesses that rent their premises are very concerned that landlords will push this extra tax to them via higher rents. The results of the Realtors’ survey mentioned previously show that 68% of respondents worried about this.

Many businesses and retail stores are suffering from the effects of the pandemic and the shift to e-commerce, and many local commercial centers are at risk of decline in occupancy in the coming years. These proposed tax reforms would strain small businesses even further at a time when they are trying to adapt to post-COVID consumer habits and the shift to e-commerce.

3. May Reduce Inventory and Transactions

If the proposed tax reforms eliminate the tax incentives associated with selling real estate (above capital gains of $500,000) and make it less profitable for investors to sell such real estate, then such reforms could reduce the number of transactions in the market.

Investors adopt a “wait-and-see” approach, holding onto their properties to see whether future administrations reverse the proposed changes to the 1031 program. In such a scenario, the 1031 exchange reforms could have a big impact on inventory. According to the Realtors’ survey referenced previously, more than half the properties that made up all the 1031 exchanges in their study were residential assets.

A further reduction in inventory in this scenario would push up prices even more, potentially increasing affordability issues for both homebuyers and mom-and-pop investors, again becoming another trigger that pushes more units into the hands of institutional investors, because they have the deepest pockets.

4. Negatively Impact Ancillary Businesses

Any significant slowdown in transactions or investments due to changes in 1031 exchange rules could impact ancillary businesses servicing the real estate industry. Some of these businesses include real estate brokerages, lenders, construction firms, contractors, insurance companies, title companies, and real estate attorneys.

According to recent research from global business consultancy firm Ernst & Young, 1031 exchanges help support an estimated 568,000 jobs across the industry, which contributes $55 billion to gross domestic product annually.

A slowdown in transactions would reduce demand for many of these services. And, once more, small businesses will be impacted the most, because they are less able to cushion the blow of a drop in revenue. For example, many small construction firms and contractors pick up a lot of their work from real estate investors who require renovations. If real estate investors begin slowing their activities, ancillary businesses will feel the impact of that slowdown. Some may even go out of business or be absorbed by a larger company.

Looking Ahead

Tax hikes aimed at the richest in society may sound appealing on paper. Once you start analyzing the impact of such tax hikes and peeling back the layers, we begin to see some dire consequences that may result. This is very much the case with the Biden administration’s proposed changes to the 1031 exchange.

The proposal could actually be a boon for wealthy institutional investors who can easily outmaneuver the little guy and actively pushing out smaller investors. The irony of this should not be lost on anyone.

That’s not to mention the risk of pushing up prices for homebuyers and creating an additional financial burden for small businesses.

If this misguided plan becomes law, real estate investors should focus on acquiring residential assets well below the $500,000 capital gains threshold. Acquiring smaller assets will ensure that investors will still be able to capitalize on the benefits of doing 1031 exchanges.

Investing in small residential assets will be a good way to weather the storm. And considering the massive housing shortage that exists in this country today, this investment strategy may prove to be a homerun in the long term.