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The Final Straw Of Real Estate: THE 1031 EXCHANGE.
This is a section of the tax code that allows you to BUY an investment property, and then “Exchange” it for ANOTHER, MORE EXPENSIVE property in the future, without being taxed on that profit in the process.
The expectation here 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 re-sets the property tax basis to a higher amount when you buy something new, it increases inventory on the market, the high transaction cost supplies money back into the economy through real estate agents, escrow companies, title companies, and inspection companies, and it prevents people from just buying and holding on to property forever until they pass away.
Right now, this new tax proposal would get rid the 1031 exchange, and limit the amount that you can defer into a new property by $500,000 per transaction…where anything over that would be taxed as long term capital gains.
However, a study was done which found that the 1031 exchange led to more liquidity on the market because owners were incentivized to sell, and THAT helped stimulate job creation, investment, and economic growth.
Like I mentioned, every time a property is sold – about 5% of the properties value goes towards selling costs, like agents, title companies, escrow companies, insurance companies, inspection companies, notary fees, and a multitude of other businesses who rely on that…and, in the process…all of THEM end up paying ordinary income tax on the money THEY make.
Second, It was also found that nearly 88% of exchanged real estate was EVENTUALLY disposed of in a taxable sale, resulting in substantially more tax being paid than would have been due had the exchange not occurred.
Not to mention, every single time a property is sold – the tax basis is re-assessed at the new value, meaning – over time – property tax revenue goes up, and the more people buy and sell – the more revenue is generated.
Property owners may also be less inclined to spend money up-keeping the property because they don’t need to maximize value, and that would lead to fewer job demand in contracting, landscaping, and so on.
It could also drive more demand for less expensive real estate, because investors would much rather get a 100% return on their money selling a $1 million dollar home that they bought for $500,000…than a 10% return on a $5.5 million dollar home they bought for $5 million.
And lastly, this could further reduce inventory on the market because investors might be less incentivized to sell, and instead…it might make more sense just to keep it, as-is.
So, even though there are some immediate benefits of reducing the 1031 exchange and generating about $41 more tax revenue over the next 4 years…the NET benefit could actually be significantly lower IF fewer people sell, and because of that, less tax revenue is generated, and fewer jobs are paid in the process.
So, I say…keep the 1031 exchange, BUT get rid of the stepped up tax basis, where heirs would pay the FULL TAX OWED at the time of passing. That way, taxes are never completely eliminated – but, they can be deferred, and then paid in the future – in full.
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