1031 Like-Kind Exchanges: On The Chopping Block, Or Here To Stay?
Researchers, Realtors and industry action groups argue that the rippling economic effects from changes made to Section 1031 would be a blow to the real estate industry and investors.
President Biden’s tax plan stands to make a significant impact on everyday citizens and investors alike.
If passed, the plan would increase taxes on the top 1 percent of earners by 13 percent to 18 percent of after-tax income, and indirectly increase taxes for most other groups by 0.2 percent to 0.6 percent, according to the Committee for a Responsible Federal Budget, an independent, non-profit, bipartisan public-policy organization based in Washington, D.C.
But one proposal that could potentially rock the real estate industry, if passed, is the end to Section 1031 “like-kind” exchanges for investors with annual incomes of greater than $400,000.
1031 exchanges allow real estate investors to defer capital-gains taxes when they sell properties by directing the sale’s proceeds into new investments. Many investors conduct these exchanges on a continual basis, and while that means the tax continues to be deferred, it’s not as though it goes away altogether — that amount still comes due to investors eventually. In fact, a 2015 study conducted by Professors David C. Ling (University of Florida) and Milena Petrova (Syracuse University) determined that nearly 88 percent of exchanges end in a taxable sale, “resulting in substantially more tax being paid than would have been due had the exchange not occurred.”
This 100-year-old tax law has been considered for repeal in the past (prior to the 2017 tax reform bill, for instance), but lawmakers have usually come around to recognize the value it has in stimulating the economy. This time, that stimulus may be especially valuable as the U.S. economy battles the impacts of the pandemic.
“Like-kind exchanges allow investments to be shifted to the most productive and efficient uses possible, providing flexibility that is desperately needed now with the commercial real estate industry facing significant challenges in the months ahead,” National Association of Realtors (NAR) President Charlie Oppler said in a statement emailed to Inman. “As one of our top policy priorities of 2021, NAR is strongly opposed to the repeal or limitation of the like-kind exchange provision, and we will continue our work to educate lawmakers on the provision’s importance to the recovery of the U.S. economy.”
One potential impact the repeal of these exchanges could have is causing investors hold on to properties for a longer amount of time, which could ultimately have a ripple effect on Realtors, appraisers, title companies, inspectors and others involved in different levels of the transaction.
“The elimination of this program for high-income investors could cause them to hold on to properties for longer than in the past and may have the effect of decreasing supply and demand,” Lowndes Law attorneys Samantha Duran and Joaquin Martinez recently said in a post for legal news resource JD Supra.
If changes made to Section 1031 does result in dissuading investors from completing more transactions, the result could actually be a decline in total tax revenue. Beyond that, an Ernst & Young study conducted in 2015 determined that a repeal of Section 1031 would slow economic growth, reduce the U.S. GDP and negatively impact small businesses.
“If Section 1031 is repealed, state and local jurisdictions which impose real estate transfer taxes on transactions will see a decline in tax revenues to accompany the decline in transactions,” Marc Landis, managing partner of Phillips Nizer LLP, said in a statement emailed to Inman. “Some of the states that could face a severe impact include New York, New Jersey, Connecticut, Delaware, Michigan, New Hampshire, Pennsylvania, Florida and Washington; municipalities such as New York City, Chicago, Los Angeles, San Francisco, Philadelphia and Pittsburgh would also take a hit.”
Data from a survey conducted in 2015 by NAR also suggests changes made to Section 1031 would have a palpable impact on individual Realtors’ transaction volume. Forty percent of Realtors said that the total bulk of their transactions would not have occurred between 2011-14 if like-kind exchanges did not exist. Another 24 percent of Realtors said between 75 percent and 99 percent of their transactions would not have occurred under the same circumstances during the same period. A whopping 96 percent of Realtors surveyed also reported that a repeal of like-kind exchanges would likely result in a decrease in real estate values.
“Every time a 1031 is done, that money that would be going to Uncle Sam, actually it’s plowed back into the deal where you have, I guess it’s like 30 jobs are created, something like that,” Daniel Wagner, senior vice president of government relations at The Inland Real Estate Group, told Inman. “Where you recognize the fact that the Realtor makes money, the appraiser makes money, the person that does the survey, and it goes all the way down, and then you get to the contractors — the union people make money, they’re going to renovate that apartment complex, they’re going to put new LED lights in, it’s going to be all that kind of stuff. So that’s a big deal.”
Wagner also told Inman that in his experience as a member of the Realtors Political Action Committee (RPAC), one of the main reasons that Section 1031 is so often put on the chopping block by legislators is the rate of turnover in Washington. He said that new or younger staffers who come in with a new administration often have no idea what it is — or the ins and outs of the waterfall benefits it can have on different layers of the economy — which puts pressure on organizations like RPAC and NAR to constantly educate lawmakers about the tax law.
But with this administration, Wagner is hopeful that if Realtors do their job of adequately educating lawmakers about Section 1031, the law will stay intact.
“So I don’t believe, if we do our job as an industry, I don’t believe the 1031 will go away,” Wagner said. “If we sit back and just assume that people know what the 1031 is about, then I think it goes away. So we have to be proactive and educate, and it’s all about education. ”