Should you sell your real estate investments before any changes to capital gains taxes or 1031 exchanges get made? That’s what many people are asking. But before you do anything, understand that there’s no telling what will come of President Biden’s tax proposals with a divided Congress, and you do have some interesting options in the meantime.
By: Dwight Kay
I’ve been a professional real estate investor since prior to the Great Financial Crisis and have seen pretty much everything: Markets that go up and down, trends that fade away versus take hold and stay and, certainly, changes in political leadership that produce new tax policies.
Now we have President Biden in the White House and are seeing his proclamations and policy positions. Let’s look objectively at indications from the administration and what could happen this year with potential implications for investment real estate.
First things first, the economy at the moment is on fire. U.S. GDP may top 6% this year, according to The Conference Board. To be sure, the recovery is uneven and Covid remains a serious factor on a global basis. But I note the macroeconomy because at my firm, we believe there’s no better indicator of potential demand for investment real estate. When the economy is expanding, demand increases, generally speaking, for income properties occupied by business users and multifamily properties that provide rental housing to people.
Watch for Changes to Capital Gains Taxes and 1031 Exchanges
In terms of tax policy, now on the table from the Biden administration are some proposals with the potential to affect investment in real estate: an increase in the capital gains tax rate and limits on the use of 1031 like-kind exchanges. (Basically, 1031 exchanges allow property investors to defer capital gains and other tax on investment gains when they reinvest the proceeds in other investment properties.) Biden has proposed raising the capital gains tax rate to 39.6% for people making more than $1 million a year.
My hope — one that is shared by many others — is that the capital gains tax rate is not increased. I believe a favorable capital gains tax rate encourages just that — capital investment. But let’s say the rate goes up: How would that affect real estate investments? Generally speaking, it would potentially reduce returns, but it would also reduce returns on all manner of investments, including on the sale of stocks, bonds and other assets. So any hit to your investment real estate portfolio wouldn’t be pretty but could be proportionate.
In that environment, the reasons for a diversified* portfolio of stocks, bonds and alternative investments that include real estate would be the same as they are now: to try to reduce risk by holding a mix of assets, including hard assets, that are not all correlated with the stock market. Investment real estate, as a reminder, doesn’t rise and fall, as a class, with the stock market. And there is the potential to generate income (positive cash flow) in addition to potential appreciation. There also are other tax advantages of real estate investment, including depreciation deductions to help shelter income.
Should You Sell Investment Real Estate Now?
In the short term, some property investors may be wondering: “Should I sell now to get ahead of any change in the capital gains tax rate?” The simple answer is maybe. There is no one-size-fits-all answer for everyone. It depends on your individual situation and the property you’re holding. If its value has held up well during the pandemic and you need to sell, it may make sense. If the value has declined but is poised for a rebound and you don’t need the proceeds now, it may make sense to wait. Of course, consult your tax or legal adviser as you consider the options, because everyone’s individual situation is different.
Biden also has proposed curtailing the use of 1031 like-kind exchanges. To be clear, he has not proposed eliminating them, but limiting their use. In the administration’s budget released in late May, there is a proposal to limit the amount of capital gains from investment property sales that can be deferred to $500,000 per year for individuals and $1 million per year for married couples. (Today there is no limit on the amount of capital gains from the sale of investment real estate that can be sheltered using 1031 exchanges.)
Notably, 1031 exchanges provide a host of benefits to the real estate market and the national economy, among them facilitating the redeployment of investment capital into more productive assets. They also are very popular among property owners, including family farm owners and small rental home and apartment building owners, to help build wealth.
DSTs Could Become Even More Attractive
If the use of 1031s becomes limited, one investment vehicle likely to become even more attractive is the Delaware Statutory Trust (DST). DSTs are a form of fractional real estate ownership that is 1031 eligible, unlike many other real estate co-investment structures. DSTs can be a great way to invest in real estate, including an important part of a diversification strategy.
I mention them because DST interests have relatively low minimum investment amounts — typically $100,000 — so corresponding gains could be below any new thresholds that may be set to qualify for 1031 tax treatment. Also, many investors own shares of multiple DSTs as a diversification strategy. So if an investor’s real estate holdings are across multiple DSTs with different sale timelines, gains in any one year could potentially not exceed whatever limit may be imposed in order to qualify for 1031 tax-deferral treatment. To learn more about DSTs and how they can be used in a 1031 exchange, visit www.kpi1031.com.
One Strategy Investors are Considering Now
Many investors are considering selling larger real estate holdings now and 1031 exchanging into a number of Delaware Statutory Trust investments at smaller price points in an effort to potentially protect themselves from 1031 exchange limitations in the future. For example, if an investor had a $3 million property that they sold and exchanged into six different DST investments in $500,000 increments, they would potentially be setting themselves up to continue to defer gains via 1031 exchanges in the future even if limitations proposed by the Biden administration go into effect. This is also because each DST has its own business plan and timeline, with property sales likely to occur at different times and in different years in the future.
What will happen on these federal tax policy issues this year? Nothing, or something — no one knows for sure. In the meantime, investment property owners and investors should make the best decisions they can today given what we know now, recognizing that regardless of the tax policy, real estate is likely to remain an attractive asset class for many investors interested in diversification and the pursuit of income and appreciation. As always, diversification does not guarantee profits or protect against losses, and income and appreciation are never guaranteed with any investments.
*Diversification does not guarantee profits or protect against losses.