1031 Exchange: Deal Or No Deal

Is “deal or no deal” a popular refrain from a successful game show or is it the voice of real estate investors who are growing concerned about the potential repeal of Section 1031 of the Internal Revenue Code?  

A recent read of the Biden/Harris tax plan reveals a $4 trillion tax hike, and one of the considerations for funding this massive tax increase is a change of 1031 Exchanges. 

President Biden’s administration has proposed eliminating 1031 “like-kind” exchanges for investors with annual incomes of more than $400,000, as part of a plan to fund future government spending on childcare and elderly healthcare. 

1031 exchanges have been a part of the U.S. Internal Revenue Code since 1921. The law was originally passed by congress to stimulate economic growth. They allow real estate investors to defer capital-gains taxes when they sell properties by directing the proceeds into new investments, usually within a few months after the sale.  As written, the rule allows investors to perpetually roll over capital gains into successive replacement property purchases, effectively eliminating tax liabilities through estate planning. 

Throughout U.S. history, investors have relied on real estate as a means of generating both income and capital appreciation. Low investment returns and stock market volatility have converged to create enormous demand for income-producing real estate that is often used to fund future liabilities. 

Now, more than ever, investors are looking to their real estate holdings to diversify away from market risk and provide a steady stream of income during retirement. For many 1031 exchange investors, their real estate holdings make up the largest portion of their net worth and are a key pillar in retirement planning.     

Today individual investors and limited partnerships control more than $ 7 trillion in residential and commercial rental property. It’s estimated that one in four Baby Boomers own one or more investment property and annual 1031 exchange transaction volume exceeds $100 billion per year.  

Given forecasted economic and demographic trends (primarily driven by the Boomers), the question is not whether or not investors will be buying investment real estate but rather what types of properties will they buy. 

In light of potential policy changes and evolving tax reform, a possibly even bigger question is will commercial real estate investors be able to utilize 1031 tax deferred exchanges as a means of buying and selling properties in the future?  

If Section 1031 of the IRS code is reformed millions of small retail investors may stand to lose billions of dollars in property values. 

This is not the first time that attempts have been made to eliminate 1031 exchanges but so far it continues to survive threats of repeal because lawmakers generally understand its positive impact on the economy. 

As Brad Watt, CEO of Petra Capital told me, “eliminating exchange rules at a time when the economy is suffering from the coronavirus pandemic would deal a ‘one-two punch’ to real estate values. 1031 exchanges benefit the “everyday” man by allowing smaller and less capitalized real estate investors to increase their income and net worth by temporarily deferring tax on reinvested real estate sales proceeds.” 

Eliminating 1031 exchanges from the current tax code could have a profound negative impact on future real estate values and the economic prosperity of the many small investors who own investment property.    

For investors looking to sell their current investment property, there has historically been a long line of willing buyers. Investors have been eager to purchase stabilized income property with the added benefits of tax-sheltered income and the ability to protect future capital gains by utilizing 1031 exchange rules. 

Now with the twin-threat of coronavirus and looming tax reform, sellers and buyers of investment properties are beginning to recalibrate pricing and income expectations. A modification, or outright elimination of IRC section 1031, could potentially create a real estate recession that mirrors the impact of the Tax Reform Act of 1986. 

However, the impact this time around could be much worse as real estate is now considered the fourth asset class behind stocks, bonds and cash. 

Now, more than ever, investors are relying on the stability of their real estate holdings to hedge against an unstable and unpredictable economy. Adverse changes or elimination of 1031 exchanges would send a shockwave through the economy that would have irreversible consequences on existing investors and potentially eliminate trillions of value in future generational wealth transfer.

Meanwhile, perhaps in anticipation of the elimination or modification of 1031s, there has been a mad rush to get deals closed. Paul Getty, CEO of First Guardian Group, told me, “our phone is ringing off the hook.”

Getty’s firm sees more 1031 transactions as anyone; as he put it, “we have a front row seat.” In December 2020 his company saw a significant spike in 1031s. Mountain Dell Consulting, which tracks 1031 transactions, reported a 15% increase from first-quarter 2020 citing, “the market does not have enough supply for current demand.”

The 1031 exchange law is one of the most important tools in the toolkit for real estate investors and odds are good that there could be changes on the horizon.

Kim Lochridge, executive vice president at Engineered Tax Services told me that “the elimination of the 1031 exchange program would be absolutely detrimental to the real estate markets and industries.”

She added, “real estate folks are learning a current work around by selling and in the same year buying another property and using the bonus deprecation (from a cost segregation study) in order to offset the capital gains on the sale.”

That’s an interesting work around, however as she pointed out, “bonus deprecation begins to phase out in 2023 and is totally expired in 2027, so this would only be a short-term alternative solution.”

Decisions, decisions.

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