Proposed Tax Code Change Likely to Cause Higher California Rents

A 'for rent' sign is posted in front of a house in Richmond, Calif. in this file photo. Justin Sullivan/Getty Images

Commentary

Southern California is expected to build 1.5 million new homes throughout the next eight years. That was the finding of a recent pronouncement by California’s department of housing and community development.

Even so, President Joe Biden’s administration is proposing a change in the federal tax code that could severely limit the likelihood that such housing will get built.

As part of its proposal to spend some $3.5 trillion on social programs and industrial programs and another $500 billion on infrastructure, the Biden administration is proposing a number of ideas it thinks will increase tax revenue, including raising the corporate tax rate from 22 percent to 28 percent.

One such tax proposal would affect the cost of capital for real estate investors by changing how they defer capital gains.

Following basic economic laws of supply and demand, an increased cost to anything will lead to fewer of those things being supplied, which would likely cause abnormally higher rents.

In this case, the Biden administration wants to change how much tax can be deferred when a property owner sells one property and buys another.

Currently, such a property investor can elect to do a 1031 Exchange, which allows them to use all sale proceeds of the first property to buy a second property, without having to pay capital gains on the initial property until the investor sells the subsequent property for cash.

The process of doing 1031 exchanges substantially reduces the cost of capital for property investors.

According to the National Association of Realtors, 40 percent of all such transactions involve multi-family homes.

The Biden administration wants to limit the benefit of 1031 Exchanges to only $500,000.

Capital gains refer to the increased value of an asset from the date of purchase, after making adjustments for depreciation and other expenses. Capital gains taxes are paid on such sales when the asset is held longer than a year.

Avoiding taxes on the first $500,000 may sound like a lot of money to many people. However, it is less than the $531,000 the City of Los Angeles is currently spending to build one housing unit under its home-building program associated with its HHH bond measure to fund housing for homeless people.

Indeed, according to a study by David C. Ling and Milena Petrova, a repeal of the 1031 Exchange program would cause rents to increase eight to 13 percent in the long run, with a more pronounced effect in high-tax states such as California.

That would be terrible for people struggling with homelessness.

The National Association of Realtors website quotes Norman Alexander, president of the Ridgecrest Area Realtor Association and a member of the California Association of Black Real Estate Professionals.

Said Alexander: “As the Black community explores avenues for growth of their financial opportunities… the 1031 like-kind exchange [as it is] is more important now than ever.”

Any legislation carries the risk of unintended consequences.

In California, any change to the tax code trying to increase taxes from property owners could lead to higher rents and exacerbate the state’s housing crisis.

Tim Shaler is a professional investor and economist based in Southern California. He is a regular columnist for The Epoch Times, where he exclusively provides some of his original economic analysis.