I tend to avoid politics and political discussion for the same reason I avoid discussing religion, sex or which Texas football team I prefer. There’s no reason to alienate or offend a healthy percentage of my readers with my opinions on matters outside my expertise!
Nevertheless, it happens from time to time that politicians say and do things that do fall within my purview. And the recent release of the president’s proposed budget for next year certainly qualifies.
So let’s dig in…
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As you may know, the Biden administration recently released its proposed budget for fiscal year 2025. Buried within the $7.3 trillion budget is a provision that would limit capital gains tax deferrals under Section 1031 of the Internal Revenue Code to an aggregated $500,000 per taxpayer annually. While there are currently no statutory limits on capital gains tax deferral, the president’s proposal would mean that real estate investors could defer only a maximum of $500,000 in capital gains taxes ($1 million for couples filing jointly) through 1031 exchanges each year. Any gains above that amount would be fully taxable.
Section 1031 has been in place since the early 1900s and is an important tool for investors seeking to preserve and grow their wealth. The proposed change would be devastating to real estate investors, to the real estate market in general and to the American economy as a whole. And yet, it has taken me a while to address it, for one important reason: I am unconcerned about its prospects of ever becoming law.
Dead on arrival
Let’s be clear: The proposal certainly warrants concern and an aggressive response from the real estate community and investors. And it will certainly get one — just as it did last year when Biden’s proposed budget for 2024 included the exact same proposal. And just like last year, the proposal (and most of the budget with it) will be deemed “dead on arrival” by Congress, including some members of the president’s own party.
To understand why this might be, and why a president would float an idea with virtually no chance of gaining traction, it’s important to understand the process of the federal budget as a whole. The U.S. Constitution grants the U.S. Congress — not the president — the so-called “power of the purse,” or the ability to tax its citizens and spend public money. So Congress can certainly take the president’s budget proposal under consideration. Or they can do what they usually do: hold hearings, debate priorities and ultimately produce a budget whose resemblance to the president’s is entirely coincidental.
It’s all politics
The president’s proposed budget is basically symbolic, which begs the question: Why bother producing one at all, much less expend the thousands of hours that go into its production? The answer, in a word: politics.
The president’s budget proposal is a political document, not a practical one. Lacking the force of law, it nevertheless is effective at signaling the administration’s priorities, appeasing various constituencies and, at its most effective, setting the terms of the public debate on certain subjects. Presidents often include items in their budgets that have virtually no chance at becoming law, but that do achieve the goals of energizing their base of voters and possibly forcing their opponents to take unpopular votes, especially in an election year.
This practice is always pilloried as wasteful by the president’s opponents, but it’s clearly a bipartisan tradition. Tracing back through the budget proposal of presidents from the past several decades, it becomes apparent that these “zombie” ideas have a consistent feature:
- President Trump proposed billions for a border wall with Mexico, which served as an effective political rallying cry, if not a serious budget proposal (as it was never going to be accepted, much less funded, by his Democratic opponents).
- President Obama annually proposed a “Buffett Rule” millionaires’ tax, endorsed by Warren Buffett himself, which stood no chance of success, but which enabled him to paint Republicans as “defenders of the rich.”
- President George W. Bush championed the concept of partially privatizing Social Security, an idea that went nowhere in Congress but signaled his conservative bona fides to his supporters.
- President Clinton included a provision to study an internet sales tax in his final budget, a poison pill for the GOP, but a bouquet at the feet of the brick-and-mortar retailers who were important Democratic constituents.
Political positioning
All of these proposals shared the same status as opening moves in a long negotiation process at best and pure political positioning (as opposed to an attempt at serious policymaking) at worst.
Which brings us back to Biden’s proposed $500,000 cap on like-kind exchanges in his 2025 fiscal-year budget. The provision would be an unqualified disaster for the real estate market — if enacted, of course.
A 2015 study by Ernst & Young examined the idea of repealing Section 1031 entirely and determined that the cost to the American economy would be over $13.1 billion. A subsequent study by two professors in 2020 concluded that the cost would be closer to $20 billion and would effectively create a “lock-in effect,” resulting in fewer transactions and, ultimately, industrywide price declines.
Not a realistic policy goal
However, once we understand the symbolic nature of presidential budget proposals, it becomes clear that the suggestion of a 1031 cap serves primarily as an opportunity to signal progressive tax priorities, not as a realistic policy goal. The chances of the 1031 cap becoming law are slim to none, just as they were when it was proposed and ignored by Congress last year. But by proposing it again this year, Biden addresses the goal of telling his progressive base that he is still trying to crack down on “loopholes for the rich,” even while moderate members of his own party will distance themselves from the proposal and tout their defense of middle-class homeowners.
They know what we know
Limiting or repealing 1031 exchanges would blast a hole in real estate values, hurt the economy and ironically reduce tax collections over time by depressing activity. Even the more limited $500,000 cap (as opposed to full repeal) would do immense damage because the vast majority of the 1031 exchange dollar volume comes from a small number of high-value transactions that would be largely gutted. Many investors would simply freeze in place, unwilling to sell appreciated assets, removing a huge chunk of supply from the market. We would also see a steep drop in demand and new investment because the after-tax returns on real estate would fall sharply. Inevitably, property values and rents would decline.
So what should you do now?
- Don’t make any panic moves or radical changes to your investment plans at this stage. There is a high probability that this provision will not pass congressional muster, just as it didn’t last year.
- Stay informed and get involved. Subscribe to my weekly newsletter and watch this space for news of any movement toward enacting this harmful proposal. Contact your representatives in Congress to voice your concerns.
- Should the proposal show signs of gaining any traction, it might be prudent to consider expediting any planned 1031 exchanges in anticipation of potential future legislative changes. However, it’s essential to avoid making rash or poorly thought-out decisions. As of now, there are no indications pointing toward restrictions or limits on 1031 exchanges, let alone their complete elimination.
As always, consult your tax advisers and legal counsel about your specific situation before making major initiatives. Everyone’s circumstances are different.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
