On July 9, President Biden signed executive orders aimed at promoting competition in the marketplace and cracking down on monopolies by further enforcing anti-trust legislation. The executive orders apply to a whole host of industries, including agriculture, pharmaceuticals, technology, and several others. The orders include a specific 72-point initiative plan to encourage government agencies to look into “some of the most pressing competition problems across our economy.” The executive orders target just about every facet of current business operations. However, their impact at the local level could be especially interesting. The orders will specifically impact the 1031 exchange as written in Dodd-Frank. This is the swapping of investment properties for others that allows for the deferral of capital gains taxes. One of the main points of Biden’s tax plan is the partial elimination of the capital gains tax loophole.
The 1031 Exchange Loophole
As it stands today, any business investing in real estate has the ability to swap valuable property they own with other properties under the IRS’ Section 1031 Exchange Rule. This means that wealthy businesses and real estate developers are consistently acquiring and then selling valuable tracts of land in order to defer a portion of their capital gains taxes. While they are not exempt from eventually paying these taxes, the loophole does allow businesses to “defer capital gains on the sale of property if the proceeds are reinvested into a like-kind property in a certain period of time.”
Under former President Donald Trump’s tax plan of 2017, the 1031 exchange timeline for acquiring comparable real estate in order to defer the tax is 90 days. So because of this, there was always a mad rush from wealthy real estate developers to acquire more property. They then could temporarily avoid the capital gains tax. When the 2017 tax plan was drafted, the 1031 exchange was actually eliminated for transactions such as the selling of art, but not for real estate. The reason for this was a large faction of Washington D.C. lobbyists demanding that this exchange go on.
The problem that this creates for small businesses is it exponentially increases the sale price of many real estate properties. They become hot commodities in a seller’s market created by the tax plan. It equates to a high price to acquire land and the general inability for mom-and-pop-type businesses to afford them. Thus, wealthy real estate developers have essentially been able to operate unfettered. This is where the anti-trust and pro-competition legislation comes into play.
Rich developers essentially control the real estate market as of now. So, they are able to operate as monopolies without the worry that a smaller business or developer may undercut them. This forces the smaller mom-and-pop businesses to rent the commercial space they desire rather than own it. When they must rent, they are not able to capture additional value that comes from physical improvements or real estate appreciation that results in part from their business’ success. On top of this, renting in this market is not cheap, so it ends up eating into the business’ margins.
Perhaps this equation is best summed up by the ‘Father of Capitalism’, Adam Smith. He criticized non-operating rentiers by saying, “As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed and demand a rent even for its natural produce. A tax upon ground rents would not raise the rents of houses. It would fall altogether upon the owner of the ground-rent, who acts always as a monopolist, and exacts the greatest rent which can be got for the use of his ground.” In other words, Smith is expressing concern over none other than the 1031 exchange loophole.
The Municipal Side of Things
One problem that has continuously come up for individuals who wish to purchase land is the 1031 exchange. As noted, it has had the effect of locking out smaller developers from purchasing valuable real estate. This is due to wealthy real estate moguls bidding way over the asking price of the property. An example of this is the real estate development company Provco Group. Provco is a Pennsylvania-based company that specializes in exploiting the 1031 exchange loophole.
While everything they do is within the law as currently laid out, Provco’s business practices closely resemble a monopoly. They buy up land, predominately in Pennsylvania, New Jersey, and Florida, and develop it for their clients. Then after the development is complete, they immediately sell the land and use the proceeds to buy other real estate properties where they can do the same thing. The cycle is extremely profitable for both Provco Group and its clients. The problem is that the Provco development hurts businesses in close proximity to it just by virtue of being there.
One of Provco’s main clients is Wawa, a very popular chain of convenience store gas stations that populate Provco’s development jurisdiction in the Eastern United States. Wawa contracts Provco to build their convenience stores and then receives a share of the profits when they sell them. For anyone that lives in Pennsylvania, New Jersey, or Florida, Wawa is synonymous with cheap gas, good food, and convenience. So it should come as no surprise that Wawas are popping up at an almost extreme rate over this area. With Provco exploiting the 1031 loophole and Wawa continuing to rake in profits, the cycle seems to be indefinite. Perhaps with these new executive orders from President Biden, the process will at least slow.
For local governments who generally have to approve land developments like Wawa, the loophole really does come into focus. At the municipal level, township supervisors vote on whether or not to approve land developments such as Wawa. The current tax system and 1031 exchange means that wealthy development companies can legally strong-arm townships into approving their projects. This is the reason why the building of Wawa and other high-impact businesses often occurs so close to homes. The zoning in many of the places Provco wishes to build is outdated and not reflective of current residents’ needs. So if a tract of land is zoned commercial, that land automatically becomes a target of Wawa to develop.
Even if the land is not zoned commercial, companies like Provco and local governments that often work hand in hand with them are able to adapt the zoning to fit what they desire to be built on that particular piece of land. Provco is also sometimes responsible for paying for roads redesigns and the like that are part of the contingency to develop certain tracts of land. When townships impose these contingencies, they and companies like Provco are engaging in tying practices. These practices are what Biden is trying to address in his executive orders. Additionally, Wawa relays interest in land to townships in many cases years before the projects become public knowledge. This effectively undercuts any smaller businesses that may have had an interest in the property. All of this amounts to a legal monopoly.
The Potential Effects
With the signing of Biden’s executive orders, there is the potential to prevent some monopoly behavior by land developers. It is important to note that Biden’s American Families tax plan will not completely eliminate the 1031 exchange rule. It will only affect purchases greater than $500,000. This means that many smaller businesses and homeowners will still be eligible to take advantage of it.
Biden’s tax plan also includes a hike in the corporate tax rate, increasing from the current 21% to 28%. This is yet another example of the Biden Administration’s attempts to force wealthy corporations to pay their fair share. This also factors into the anti-trust legislation because it means that companies and real estate developers may be less willing to bid obscene amounts for low-priced properties. They will be forced to pay more in taxes and will be unable to take advantage of the 1031 loophole. The ultimate results of this legislation are certainly debatable, but we can not overlook its pro-competition agenda.
Another potential effect of these executive orders is that real estate properties will likely experience less turnover. This is due to the fact that without the 1031 exchange, there will be less incentive to sell a profitable property that can not be flipped for equal value. Also, developers like Provco Group will be unable to use the law to their benefit. So, the effect of less real estate turnover theoretically is lower asking prices on specific properties. This is because there will be less motivation to move the property if developers can’t take advantage of the loophole. This means that there is potential for smaller businesses and lower-tier developers again being able to purchase valuable land.
The Bottom Line
There is no guarantee that President Biden’s American Families Plan will move forward, but the executive orders will take effect. So, if the goal of the orders is to further reinforce anti-trust laws, then perhaps it will be successful. But the lobbyists who successfully preserved the 1031 exchange loophole for real estate are not going anywhere. Also, big corporations and savvy lawyers always fight tax raises, especially corporate tax hikes. In order for congress to pass his tax plan, Biden will likely have to adapt it. And with the 2022 Midterm Elections fast approaching, a potential Republican takeover of the House of Representatives or Senate could further complicate his plan. Only time will tell how effective Biden was in his pursuit of competition in the marketplace.
*Ilya Breyman, a tech entrepreneur based in Bucks County, P.A., contributed to this article.
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