Valuable Real Estate Tax Benefit Should Escape The Chopping Block, But For How Long?

Before the election, President-elect Joe Biden said he’d look to axe one of small businesses’ most valuable tax benefits. With Democrats taking Senate control, the risk is potentially heightened.

Fortunately, for those who own commercial real estate, eliminating the 1031 exchange probably won’t make Biden’s near-term agenda after all.

The 1031, also known as a like-kind exchange, benefits small business owners who want to sell their properties. It allows sellers to defer capital gains tax when their proceeds are reinvested into other investment properties.

Right now, the 1031 exchange is more important than ever. During the coronavirus-caused economic downturn, it has helped relieve the tax burden on those who are selling investment real estate that may be tied to struggling sectors such as hospitality. Investors who own other types of real estate, such as rental homes, apartments, retail centers, restaurants, bars, farms, and ranch lands may also use a 1031 exchange.

Dodged A Bullet For Now

However, with COVID-19’s recent resurgence, the focus of the new administration will likely be on health and economic stabilization. At the same time, infrastructure will be a heightened focus, especially for the first two quarters of 2021. And even if a proposal to narrow or eliminate 1031 exchanges was brought forward, it seems unlikely (though anything can happen), that Congress will take on efforts to cancel or modify Section 1031 of the Tax Code for now.

This is great news for business owners, entrepreneurs, and commercial real estate investors. Indeed, it can be good for job growth and the economy overall. 1031 exchanges facilitate liquidity—particularly important for small business owners or individuals who don’t have access to the same sources of financing as larger institutions. Not only that, but these transactions can often boost local employment as suffering properties are transferred to owners who have the time and resources to invest in improving and maintaining the property.  

Incentives to transform out-of-favor properties into new uses can have far-reaching, positive effects throughout local communities.

Historical Success

Section 1031 like-kind property exchanges have been part of the American real estate DNA since 1921. Tax-deferred exchanges give businesses — and ordinary people — much more flexibility and liquidity than they would otherwise have in reallocating their investments.

As much as 20 percent of commercial real estate transactions over the last decade relied on 1031 like-kind exchanges, according to a 2020 economic study by professors David Ling and Milena Petrova.

A stubborn misconception clings to the 1031 exchange: That it’s a loophole used primarily by ultrahigh net worth individuals and corporations to avoid paying taxes. That led to a proposal by the Obama administration to limit 1031 deferrals to an annual $1 million per person. Republicans considered eliminating it as part of the 2017 tax reform bill. Biden said he’d consider phasing the benefit out for investors with incomes over $400,000.

That would fly in the face of mounting evidence that 1031 exchanges benefit a much broader group of Americans, while contributing federal, state, and local tax revenues, creating liquidity and deal flow in the real estate markets, and creating jobs.

 The Ling and Petrova study —which reviewed more than 1.1 million commercial real estate transactions—found that many perceptions about 1031s are false.

For one, exchanges may lead to future taxable transactions, offsetting some fears that 1031s erase tax revenue entirely. According to the study, on average 63 percent of 1031 exchange properties are eventually sold in a taxable transaction at a later date. Of course, it's impossible to determine what real estate transactions might have occurred — or not — without the 1031 benefit.

The study also found that like-kind exchanges result in 7% less debt compared to taxable transactions, reducing the financial vulnerability of the real-estate sector. 

A separate economic study in 2015 by Ernst & Young found that that eliminating 1031s would result in less tax revenue and shrink the U.S. economy by up to $13.1 billion annually.  Even if the pandemic hadn’t revealed its benefits in such sharp detail, the economic fallout from cutting the tax benefit could be devastating.

Huge Economic impact

By keeping money flowing through real estate investments, 1031s stimulate and support a plethora of jobs in the sector, ranging from title company employees to appraisers to contractors who are hired when people buy and improve properties. The Ling and Petrova study found that a repeal of section 1031 could result in lower investment activity, a fall in real estate prices, an increase in rents, an increase in holding periods for property, and a rise in the use of debt.

Even at the best of times, that would be an economic blow to businesses and communities across the country. Without it, more investors are likely to sit on their properties to avoid taking a tax hit, slowing the repurposing of property.

With 1031s in place, someone who owns a restaurant or retail store will more easily be able to sell to another investor who plans to turn the space into its highest and best use. Take away the 1031 incentive, and there’s significantly less chance of that sale occurring. The result: more underutilized properties, more depressed areas, less economic activity, and fewer jobs.

If the Biden administration’s goal is to revive the economy, create jobs, and bring back business and consumer confidence, getting rid of 1031 exchanges would be an effective way of shooting the economy in the foot.

Jill Mozer is Managing Director for Black Creek Exchange at Black Creek Group.