Update: The proposed $500,000 cap on 1031 exchanges did not appear in the House Ways and Means Reconciliation Bill released on September 15, 2021. Although the issue could be raised again in future negotiations, for now it appears 1031 exchanges are safe.
What The Proposed New 1031 Exchange Rules Could Mean for Commercial Real Estate Lending
The commercial real estate industry has been holding its breath since the government announced that they are proposing to end the 1031 Exchange tax advantage. The 100-year-old benefit — which allows property investors to roll the proceeds of commercial real estate sales into future like-kind purchases and defer capital gains taxes on the profit — has been on the chopping block for a while.
Why Do Away With the 1031 Exchange?
President Biden announced that part of his “American Families” plan would seek to abolish 1031 Exchanges for real estate gains above $500,000. It’s part of an initiative to fund spending on infrastructure, free preschool, and free community college amongst other services. While there has expectedly been much outrage from investors, citing its crippling effect on their ability to do deals, the Trump administration initially voiced doing away with it as part of his tax code overhaul but ultimately left the exchange in for real estate transactions.
Who Would be Most Affected by the Elimination of the 1031 Exchange?
According to bloomberg.com the sector most affected by a potential tax code change is individuals who own properties in their own name (as opposed to a company name). These individuals stand to gain $5.7 billion from utilizing the 1031 Exchange in 2021. Corporations, comparatively will benefit to the tune of $2.3 billion.
Individuals often use 1031’s as a tool to pass on wealth from one generation to the next. Currently, all deferred capital gains taxes from the exchanges are forgiven at the time of the property owner’s death.
The wider ramifications of modifying the exchange would be immense.
How Commercial Real Estate Lending Would be Affected
1) Fewer Deals Means Fewer Loans
Like-kind exchanges are used in 10% to 20% of commercial real estate transactions, according to the CRE website GreenStreet.com. The restructuring of the 1031 Exchange code would certainly result in fewer deals for lenders.
2) A Possible Increase in Smaller Residential Deals
Rather than buying larger apartment buildings, individual investors may look to invest in smaller 1-4 unit real estate that can be bought and sold for under $500,000 and thus still qualify for a 1031 Exchange under the new code.
3) Livelihood of Mortgage Brokers and others in CRE Would be Affected
According to a study by Ernst and Young in partnership with the Section 1031 Like-Kind Exchange Coalition (on the impact 1031 exchanges will have on the U.S. economy in 2021), the exchange generates 568,000 jobs and 55 billion dollars annually across the CRE industry. Along with lenders and brokers, the incomes of appraisers, title insurance agents, and lawyers would be impacted.
4) Fewer Sales Could Lead to a Drop in Value
If less real estate is being bought and sold, fewer investors are adding value through upgrades which could eventually lead to stagnation or even a drop in value impacting loan amounts.
Take a breath. The proposed changing of the 1031 Exchange is fraught with political risk for the President. While proposing it may sound good to certain elements of his party, there are other, more centrist elements (notably Democratic Senator Joe Manchin of West Virginia) that are crucial to the president’s long term successes and act as a counterbalance should he swing too far to the left.
There are also the facts to consider. Studies that show that almost all 1031 Exchanges eventually end in a taxable sale and not endless deferment. Moreover, the blow back from the real estate industry citing potential job losses, real estate price drops, and a drop in taxes (from rents, transfer taxes, and income taxes from people employed in CRE) would be intense, particularly from lobbyists. For CRE investors and lenders, the writing is by no means on the wall.