Now that the election is over, the conversation over the repealing of Section 1031 of the Internal Revenue Tax Code has begun to pick up steam again. And, like all the other times it has come up, the topic will calm down and the Democrats will figure out another way to raise money through other taxation techniques, just like they have before.
During his campaigning, Joe Biden has suggested eliminating the 1031 Exchange for real estate investors with annual incomes of more than $400,000 in order to help pay for a ten-year $775 Billion Dollar plan that would pave the way for a universal preschool, eliminate home care waiting lists for those on Medicaid and create tax credits for low-income and middle-class families to help pay for childcare, as well as other initiatives. On paper, this may look like a good idea to jump start this particular sector of the economy, however, targeting real estate investors is not the way to go about it. In fact, it would ultimately be catastrophic to our economy and even have devastating effect on the very people he is trying to assist. It is a false promise as this tax increase would finance only a very small fraction of the cost of his new spending plan. Repealing the 1031 Exchange will harm economic growth, threaten jobs and literally “tilt” the commercial real estate industry on almost every level.
Critics of the 1031 Exchange argue that it is a “loophole” that allows real estate investors to avoid paying taxes. This is simply not true because the provision in the tax code only defers the tax owed, it does not eliminate the tax owed. Other arguments include the exchange provision only favoring developers, large corporations and the uber rich.
This is all likely due to the lack of understanding regarding the rules of the exchange, who actually uses it and who it ultimately benefits, which is still truly alarming considering it has been part of the federal tax code for exactly one hundred years as of 2021.
Less than 5% of exchanged properties are held by large corporations, with the majority owned by “mom and pop” investors-and more than 80% of those exchanges end up in a taxable sale (which is mostly due to lack of knowledge and professional guidance; fodder for another topic at another time).
Most real estate developers do not qualify for an exchange because their real estate holdings are considered “inventory” and are not held for qualifying investment purposes. The same goes for residential “fix & flips” – they do not qualify. However, where this process of exchanges does benefit the developers, is when a qualifying investor sells their long-time hold due to delayed or unmanageable deferred maintenance and they have an opportunity to “add-value” or reposition the asset, which provides more work for skilled construction trades and ultimately revitalizes older communities. To further illustrate the harm repealing would have on investment property, without it, the holding periods would increase even further on already obsolescent assets as investors would be encouraged to retain these assets longer to avoid paying capital gains taxes. Owners will continue to sit on their on their investments and the growth opportunity for putting the asset to better use will be wasted and revitalization will take longer to happen.
Among the rules of the exchange is the rule of replacement which requires “equal or greater in value” meaning that exchangers are typically “trading up” in their exchange, which requires and satisfies the replacement of debt (if existing debt was present on the “downleg” or relinquished property). Repealing the exchange provision would have significant impact on the commercial lending industry as investors would no longer need to satisfy these requirements.
In 2015, the Senate Finance Committee’s Report found that the repeal of the 1031 provision would cause:
- Longer holding periods (the “lock-in” effect), greater reliance on debt financing, and less productive deployment of capital in the economy, resulting from higher tax burdens on business transactions.
- Increase in the cost of capital, discouraging investment, entrepreneurship and risk-taking, and slowing the velocity of investment.
- Slower economic growth, reduced levels of investments, and reduction of gross domestic product (GDP), even if the revenue generated from repeal was used to lower tax rates.
- Concentrated burden in those industries that rely heavily on like-kind exchanges, such as real estate brokerage, construction, truck transportation*, equipment/vehicle rental and leasing* with an aggregate drop in annual GDP of $26 billion on the 10 most impacted industries. (*The ability to exchange personal property/business equipment was repealed in 2017).
The total impact on overall long-term U.S. GDP would be an annual drop of $8.1 billion.
Remember, this was from five years ago and it has already been determined that this estimate is grossly underestimated.
In addition to the above report, Ernst & Young also completed an independent study that not only agreed with the Senate Committee’s report but also concluded that:
“Repeal of the 1031 would be at cross-purposes with the stated goals of tax reform. Repeal would impact the U.S. economy adversely by discouraging investment, causing a reduction in GDP, a contraction in the economy, and would unfairly burden certain industries and taxpayers. Moreover, a reduction in GDP would result in less tax revenue, thus, repeal of §1031 would not be revenue neutral in the long run.”
Two years later, in 2017, the topic came up yet again, with the Tax Cuts & Jobs Act of 2017 and two more studies were conducted, again by Ernst & Young and the more notable report that was provided by Ling & Petrova. Elected officials once again, quickly came to the realization that not only was the cost of “like-kind” exchanges to the Treasury grossly overstated, but that an outright repeal would devastate several important industries, harm the economy as a whole, and in the end cost the government in the long run.
I believe it is pretty easy to see that while this conversation always seems to gather momentum around election years, it would not be in the best interest of our national economy to give it any real chance of coming to fruition. The 1031 is and will continue to be a very useful vehicle employed by a broad cross-section of America and continues to encourage investment not just in the economy but to the revitalization of obsolescent communities from coast to coast.
If you are an investment property owner who is interested in a no obligation, private consultation, please visit www.Best1031Online.com, or contact James Bean of SVN-Rich Investment Real Estate Partners, CA DRE# 01970580, at 805-779-1031, or email at [email protected].
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All information is deemed to be accurate, and not advice. All investors/taxpayers should consult their CPA, tax attorney and investment advisors.
