August Newsletter: The Tax Proposal That Could Create a New Wave of Real Estate Deals

For nearly 30 years, one important real estate tax benefit has remained frozen in time. Under Internal Revenue Code §121, homeowners who meet the ownership and use requirements can generally exclude up to $250,000 of gain from the sale of a primary residence, or $500,000 for married couples filing jointly. Those limits have not changed since 1997, despite significant increases in home values across the country. The proposed More Homes on the Market Act would double those exclusions to $500,000 and $1 million respectively and provide for future inflation adjustments. The legislation has attracted significant bipartisan support, but it has not yet become law.

Why does this matter to the real estate market? One of the less obvious factors restricting housing inventory is what might be called a tax lock-in effect. Consider a couple who purchased their home decades ago for $200,000 and could now sell it for $1.2 million. Before considering adjustments to basis or selling expenses, they may be looking at approximately $1 million of appreciation. Under today's $500,000 joint exclusion, a significant portion of that gain could still be taxable. Faced with that potential tax bill, and perhaps a low existing mortgage rate, some homeowners simply decide not to sell. Increasing the exclusion could remove one more financial reason for long-term homeowners to remain in properties that no longer fit their needs.

That could be particularly meaningful for families. An older couple living in a four-bedroom home may want to downsize, relocate closer to family, or move into a lower-maintenance property, but a large capital gain can make the decision expensive. If a larger exclusion encourages that homeowner to sell, the result is not simply one additional listing. Their home may become available to a growing family, while their purchase of a smaller property creates activity elsewhere in the market. Multiply that process across thousands of homeowners and the legislation could help produce something the housing market desperately needs: more movement and more inventory without building a single new house. Supporters of the legislation specifically argue that reducing this equity-related tax barrier could free up existing housing stock for younger and first-time buyers.

There is also an important opportunity for real estate investors. Investors do not receive the §121 primary-residence exclusion simply because they own rental or investment property, but they operate in the same real estate ecosystem. More homeowners selling means more transactions, and more transactions can create acquisition opportunities. A dated home owned for 30 years may be a candidate for renovation. A large property may have redevelopment or rental potential. Someone downsizing may decide to move equity from a residence into income-producing real estate. Increased turnover can therefore create opportunities for investors, developers, brokers, lenders and other real estate professionals throughout the transaction chain. In a market where many investors have spent the last several years searching for deals amid limited inventory, simply getting more properties into circulation could be significant.

This is also where §121 and §1031 exchanges intersect. Section 121 is primarily a tax exclusion for a qualifying principal residence, while §1031 generally provides tax deferral when qualifying real property held for investment or business is exchanged for other qualifying investment or business real estate. The two provisions serve different purposes, but real-world properties do not always fit neatly into one category forever. A homeowner may convert a former residence into a rental before eventually selling it, or an investor may eventually convert rental property into a residence. In certain circumstances, portions of a transaction can involve both §121 and §1031 considerations, subject to specific ownership, use, depreciation and nonqualified-use rules. That makes planning before a property is listed or converted particularly important.

Ultimately, the More Homes on the Market Act is interesting because its impact could extend well beyond the homeowners receiving the tax benefit. If enacted, it could give longtime homeowners greater flexibility to sell, help families gain access to homes that have been held off the market, and create additional acquisition opportunities for investors. Meanwhile, §1031 would continue to provide investors with a separate mechanism for moving equity from one investment property into another while generally deferring recognition of gain. Put together, these provisions illustrate an important point about tax policy and real estate: when owners have better tools to move their equity, real estate moves too. For investors, homeowners and real estate professionals alike, that additional movement could be exactly what today's market needs.

Exchange Resource Group, LLC

(303) 789-1031 • Info@erg1031.com

www.ERG1031.com