What Biden's Proposal Means for REIT Investors
We think the proposed elimination of the 1031 exchange will have limited impact on U.S. REITs.
While the Biden administration's proposed elimination of the 1031 exchange to raise tax revenue to fund the American Families Plan has caused concern among many real estate investors, we believe that the impact to U.S. REITs will be very limited. Over the past several years, REITs have disposed of tens of billions in assets each quarter and yet only rarely used a 1031 exchange to avoid capital gains taxes. If REITs pay out 90% of taxable income as dividends to shareholders, they avoid paying any corporate taxes. As a pass-through investment vehicle, the dividends paid by REITs are not considered qualified income like dividends paid by most other companies and thus are usually taxed at the highest tax bracket for each shareholder. However, part of the dividend can be reclassified as capital gains and thus taxed at a significantly lower level. Therefore, if the REIT recognizes capital gains on dispositions, the taxes owed by the shareholder on the dividend payment received from the REIT falls.
This means it is to the shareholder's advantage that the REIT regularly disposes of assets and records capital gains. Thus, REITs tend to only use the 1031 exchange when dispositions in a given year are so high that the capital gains recorded exceed the amount of the dividend payment that can be converted from ordinary income to capital gains income. We believe that the elimination would therefore have a very small impact on the few times when disposition activity is extremely high and can easily be avoided by strategic management decisions. If the 1031 exchange is eliminated and the market negatively reacts to the news, we believe this could be a good entry point for investors looking for a position in the real estate sector.
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