Dave Foster – Is The 1031 Exchange Going Away? Ep. 241

Synopsis

Dave Foster is back on my show again. For those who didn’t catch him last time, Dave was in Episode 161 where he taught us everything we needed to know about the 1031 Exchange.

As a qualified intermediary for 1031 Exchanges, Dave is a great source for getting insights into the possible impact of President Biden’s plan to eliminate the 1031 Exchange. Will this really help our government generate more tax dollars? Or will it gravely impact our economy instead? What about the plans to reform the Stepped-Up Basis – will this affect American families’ estate planning?

We cover all of this and more as Dave comes in and sheds light on those questions.

Key points

What Is A 1031 Exchange?

The 1031 Exchange is a powerful tax avoidance tool used to sell real estate that has either highly appreciated or depreciated. Through it, you can use the proceeds from the sale to buy more real estate and defer paying the 15-20% expected capital gains taxes.

By being able to avoid paying those taxes, you can take those gains and use them to buy a bigger property. 1031 Exchanges can be done over and over again until you die. Dave calls this the ‘4 Ds’, which stands for ‘Defer, Defer, Defer, and Die’. This means that a property owner can keep deferring on paying the taxes, get a bigger and bigger property each time they do an exchange, and later on, pass on their property to their heirs.

When that property gets passed on to their heirs, another tax rule called the Stepped-Up Basis comes into place. This allows heirs to inherit property without needing to pay taxes on the gains made by the property.

The Economic Impact of Eliminating 1031 Exchanges

Here’s the deal. Without the 1031 Exchange, property owners won’t be incentivized to sell their property. If they don’t sell, there’ll be less inventory. Do you know what happens when inventory is low? Prices go up.

If you’re already finding it hard to buy houses now, imagine what it’d be like when there’s a massive drop in the number of people willing to sell.

And it won’t stop there. All the other businesses involved in buying houses such as those in construction and title companies will experience income loss from fewer house sales.

This in turn will impact the income taxes they would have paid resulting in the federal government generating less money. With approximately 5,000 exchanges that happen every year, this move could stagnate the amount of economic generation driven by 1031 Exchanges.

What About The $500,000 Limit For Deferrals?

The average sale price of properties going through 1031 Exchanges is around $300,000-400,000. This provision setting a limit for deferrals won’t really benefit the majority. The reality is that there would only be a few properties with that amount of gain.

No Significant Tax Benefit For Limiting 1031 Exchanges

Let say a $300,000 property was sold via a 1031 Exchange. That transaction would have led to $15,000 in commission, $2,000-3,000 paid to a title company, and $5,000-6,000 spent on cleaners, painters, and other vendors. There’d be a couple thousand more spent on an attorney for the paperwork.

Each one of those providers would have paid income taxes for their services.

By charging capital gains tax, the government gets to earn $20,000, but the government ends up losing the $15,000 from the ordinary income tax they would have collected.

1031 Exchanges Mitigate Inflation

Our government has printed money in a bid to pour money into the economy. The downside of this is that prices of goods and services rise.

Compared with that, 1031 Exchanges encourage the sale and purchase of real estate. This improves the velocity of the prices of goods and services. This means Exchanges make $1 work twice as hard, and they fight inflation.

Is The 1031 Exchange Really Getting Eliminated?

Luckily, we have three branches of government, the Executive, Judiciary, and Legislative branches. All have checks and balances against each other.

Before the tax code can be changed, the proposal would have to be presented to the Executive Branch. It has to be voted on by both the House and the Senate. Then it has to be signed by the President himself.

In the past, having a Senate and Congress dominated by different parties meant they were at a constant gridlock. Now both the Senate and Congress come from the same party.

In theory, they could all align and make this change happen quickly. But certain Democrats have been seen to act more like Republicans in their rhetoric and decision-making. Also, there are Democrats who think this proposal is not good enough and are pushing for the President to do more.

Expect that this could mean that it might take a year before anything could happen. Maybe the proposal would get voted on in 2022, but then it wouldn’t take effect until 2023.

Hopefully, as the Federal Government is working on its spending bill and determines how much they want to spend, it’ll be a while before a final decision gets approved.

Likewise, a possible realignment of majorities is on the horizon as the midterm elections take place in 2022.

What About The Stepped-Up Basis?

The Stepped-Up Basis gives the opportunity to transfer generational wealth. This allows parents the ability to give their children better lives. Taking away that ability to gather assets and wealth that can be passed on to the next generation could result in a lot of backlashes.

But it is expected that removing the Stepped-Up Basis could add a lot of money into government coffers. While the timeline for the change could happen within the next couple of years, there’s a chance that it can be retroactively applied in 2021.

If this happens, children who inherit homes that have been in their family for many generations could potentially lose the house, if they can’t pay the estate tax.

What Can You Do Now?

We don’t know for certain what’s going to happen yet. When something changes, respond and figure out how to deal with that.

Expect that creative people will find ways to start entities and trusts, which their children will be a part of. This will make sure their properties can be transferred to their heirs.

So do proper estate planning. There are many tools and providers who can help you with that.

Last Words Of Advice

Always carry an umbrella and plan for rain.

But don’t take it out until it rains

References

More from our guest

• Get in contact with Dave through his website: www.the1031investor.com
• Episode 161: What You Don’t Know About the 1031 Exchange with Dave Foster