Update: Breathe a sigh of relief; The proposed changes to the 1031 exchange rules – a $500,000 cap – have not been adopted. 1031 exchanges are still in the clear!
The commercial real estate industry has been holding its breath (reminder, you can breathe now) since the government announced that they are proposing to end the 1031 exchange tax advantage. How does a 1031 exchange work exactly? It allows property investors, most commonly individuals, to roll the proceeds of commercial real estate sales into future like-kind purchases and defer capital gains taxes on the profit. It’s a benefit, added to the tax code in 1921, that’s been on the chopping block for a while.
At the risk of sounding alarmist, capping or ending 1031 exchange properties could decimate CRE.
Research by Ernest and Young bears that out, like-kind exchanges were forecasted to contribute the following in 2021:
We’d potentially see much of that come to a quick end.
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 too as part of his tax code overhaul but ultimately left the 1031 real estate exchange in place.
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 investment exchange in 2021. Corporations, on the other hand, 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.
Like-kind exchanges are used in 10% to 20% of commercial real estate transactions, according to the CRE website GreenStreet.com and research by the University of Florida and Syracuse University. The restructuring of the 1031 exchange code would certainly result in fewer deals for lenders.
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.
Let’s revisit that Ernst and Young study and recall that the exchange generates 568,000 jobs and $55.3 billion annually across the CRE industry. Whether it’s a 1031 land exchange or a completed structure, a major change or cap to 1031 exchange investment property would cripple not just the lenders and brokers but also cut the incomes of appraisers, title insurance agents, lawyers, and others involved in CRE.
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.
Again, take a breath and rest assured.
The proposed changes to 1031 exchanges are fraught with political risk for the President. It’s a big reason why presidents from both parties haven’t touched it in 100+ years. While proposing it may sound good to certain elements of President Biden’s party at the moment, there are other, more centrist folks (notably Democratic Senator Joe Manchin of West Virginia) that are crucial to the President’s long term successes and function as a counterbalance should he swing too far to the left.
There are also the facts to consider.
Studies show that almost all 1031 exchanges eventually end in a taxable event and not endless deferment. Let’s not underestimate the potential job losses and real estate price drops from the real estate industry. Not to mention that the decline in taxes from rent, transfer taxes, and income taxes from people employed in CRE would be immense. Blowback from all those individuals and lobbyists would be, and is, immense.
Moreover, with so many buildings and properties across the country needing to be repurposed or revitalized due to the pandemic, now would be exactly the wrong time to hamstring CRE investors.
For CRE investors and lenders, the writing is by no means on the wall on this one.