In economics, the principle of “no free lunch” holds true—spending without eventual payment is unsustainable. A recent tax proposal continues this trend of spending while significantly increasing taxes on real estate owners. Key changes include the elimination of the 1031 exchange and the step-up in basis upon death, along with taxing capital gains as ordinary income. These shifts raise several critical questions: What do these changes mean for real estate owners? Will these proposals pass?

Key Components of Biden’s Tax Plan

President Biden’s proposed tax plan features three major changes that will drastically impact residential and commercial real estate through substantial tax increases:

1. Elimination of the 1031 Exchange: A 1031 exchange allows investors to defer paying capital gains taxes when they reinvest proceeds from a sold property into a similar property of equal or greater value. This mechanism supports both commercial and residential investment, and its removal would significantly affect real estate transactions.
2. Taxing Long-Term Capital Gains as Ordinary Income: Under the new plan, capital gains would be taxed at ordinary income rates for those earning over $1 million, potentially raising the top rate on long-term gains from 23.8% to nearly 45%.
3. Elimination of the Step-Up in Basis: The step-up in basis adjusts the value of an inherited asset to its market value at the time of inheritance, thereby minimizing capital gains taxes for heirs. Removing this provision would increase tax burdens on inherited properties.

Economic Impact of Eliminating the 1031 Exchange

A 1031 exchange defers taxes on capital gains, promoting reinvestment in real estate. Contrary to the belief that it primarily benefits large investors, most 1031 exchanges involve transactions under $1 million, aiding smaller investors. If eliminated, the immediate effects could include:

• Decline in Property Prices: To offset increased tax burdens, property prices could drop by 8-12%, with rents rising 8-13% in the long term.
• Reduced Real Estate Investment: Investors would likely hold onto underperforming properties, leading to decreased transaction volumes and less optimal capital utilization.
• Wider Economic Consequences: Lower real estate activity could slow employment growth, especially in high-tax states.

Increased Taxes on Long-Term Capital Gains

Biden’s plan aims to tax long-term capital gains as ordinary income for high earners, nearly doubling the top rate. This change would eliminate the fallback strategy of holding property for favorable tax treatment, leading to higher tax liabilities and potentially discouraging investment in real estate.

The Elimination of the Step-Up in Basis

Removing the step-up in basis would increase taxes on inherited properties. For instance, an inherited property bought for $100,000 and now worth $1 million would have its capital gains calculated from the original purchase price, leading to a taxable gain of $900,000. This change could significantly affect:

• Farmers and Ranchers: Often asset-rich but cash-poor, these individuals might face insurmountable tax bills upon inheriting property, potentially forcing sales of family-owned lands.
• Small Business Owners: With significant assets tied up in business equipment and property, the new taxes could create liquidity issues, compelling heirs to sell inherited businesses.
• Middle-Class Property Owners: The $5 million estate tax exemption might seem substantial, but with the elimination of the step-up in basis, many middle-class families could face hefty tax bills on appreciated assets.

Likelihood of Passage

Given the current political landscape, the passage of Biden’s tax plan appears uncertain. However, the recurring theme of increasing taxes on real estate suggests that similar proposals may continue to emerge. Real estate professionals must stay informed and prepared for potential changes that could significantly impact their investments and financial planning.

President Biden’s proposed tax plan introduces significant changes that could profoundly affect real estate owners. The elimination of the 1031 exchange, taxing long-term capital gains as ordinary income, and the removal of the step-up in basis all pose substantial tax increases. While the plan’s passage remains uncertain, its potential impact on real estate investment and the broader economy warrants close attention.