Whenever Washington politicians act like they’re serious about deficit reduction or tax reform, certain revenue-raising proposals find their way onto lists of proposed policy changes.
One of their recent favorites is the idea of limiting or removing altogether the ability of commercial property owners to defer capital gains taxes on real estate transactions, a practice known as 1031 exchanges, thanks to the provision’s home in section 1031 of the IRS tax code. You’ll also hear these referred to as “like-kind exchanges.”
Simply put, and with the understanding that there are many caveats and compliance details, a 1031 exchange is a process that under certain limited circumstances allows a commercial property owner to defer paying capital gains taxes at the time they sell a CRE investment property.
To accomplish this wealth-creation tax strategy, within 45 days of the sale, the investor must identify specific like-kind properties they might purchase and then subsequently reinvest all of the funds from the sale (aka “down-leg”) into the purchase of one or more of those replacement properties (aka “up-leg”).
The Logic Behind Tax-Deferred Like-Kind Exchanges
Deferring taxes through this kind of like-kind transaction makes perfect sense in the world of CRE, if not the halls of Congress. After all, when a property owner sells that property, even at a gain, and then reinvests all of the proceeds (and often additional capital) into another property, there’s no liquidity available with which to pay a capital gains tax bill.
Creating a tax liability at that point would be unfair given that the investment is essentially rolled over, not “cashed in.” It would be similar to an individual taxpayer being taxed on a full rollover of a corporate 401(k) retirement account into an individual IRA.
Further, the 1031 exchange provision encourages property owners to periodically upgrade their portfolios, which creates opportunities for new entrants in the property investment market who are more likely to make improvements and inject fresh capital to update these properties that may have deferred maintenance issues.
In short, properties are enhanced, and room is made for new entrants into the market – both are policy and market positives.
A recently released letter to Congress posted by the National Multifamily Housing Council (NMHC) points out additional societal and economic benefits of like-kind exchanges. It explains that the “overwhelming majority” of properties purchased through 1031 exchanges are ultimately disposed of in non-1031 exchanges and, therefore, the capital gains are ultimately fully taxed.
The Economic Impact of Repealing the 1031 Exchange Provision
As with so many elements of our tax code, nearly any tax-related policy change can have secondary consequences that may be unintended, but in hindsight are very predictable.
Policymakers typically don’t consider the downstream economic harm that could come from repealing the 1031 exchange IRS code. For one thing, the repeal would reduce real estate transactions … along with all the affiliated taxable economic activity from industries like lending, construction, legal, accounting, title, appraisal, property inspection, etc.
Similarly, projected net revenue increases from a repeal are typically overstated since these analyses, according to the NMHC letter, often discount the impact on state and local government revenue related to taxes and fees for property transfers, deed recording, and similar activity.
Further, a more stagnant CRE market would reduce jobs in the sector. The 1031 exchange allowance supports more than 500,000 jobs and generates $27.5 billion in labor income according to an analysis last year by accounting firm Ernst & Young.
Who Benefits from the 1031 Exchange Program?
Recent data shows that the median price of a property involved in a 1031 exchange is $575,000 and 75% of the transactions are for less than $1.5 million.
The majority of these deals are made by individuals, families, partnerships, and LLCs who are taking advantage of the provision just one time (as the NMHC letter confirms). They ultimately sell that property outside of the 1031 exchange program.
These small investors and business owners are the people that benefit most often from the allowance and would be hurt the most by its repeal since capital gains tax is actually double taxation. An investor uses after-tax dollars to purchase the CRE investment and would essentially be taxed again on the gain if there were no 1031 exchange allowance.
1031 Exchange Support
Executing an IRS-compliant 1031 like-kind exchange is a complex and time-sensitive transaction. The cost of getting it wrong by missing key deadlines and other missteps can be the difference between a profitable transaction and an investment that pays off far slower or actually loses money.
If you’re thinking about trading up with your business investment property or commercial real estate investment, just remember that now may be the best time since many policymakers have their eyes on the 1031 exchange provision and it may not be around for long!
We’re watching the situation closely so please contact us. We’d be happy to help you plan for a 1031 exchange and then walk you through the process so you can reap the full benefit of this tax provision.
Don’t wait too long, though!
