By: Louis Rogers, founder and chief executive officer, Capital Square
This is the second part of a multi-part series. Part 1 can be read here.
Presidential hopeful Joe Biden’s plan, called “The Biden Plan for Mobilizing American Talent and Heart to Create a 21st Century Caregiving and Education Workforce,” would disqualify nonrecognition under Section 1031 of the Internal Revenue Code for taxpayers with income in excess of $400,000.
Is this $400,000 of taxable income? Does the $400,000 threshold include the gain sought to be deferred in the exchange? No one knows.
The adverse impact would be compounded by other parts of the Biden Plan:
- tax capital gains as ordinary income for high earners,
- increase ordinary income tax rates, and
- eliminate the step up on death (end “swap till you drop” under Section 1031).
Repeal of Section 1031 would seriously harm real estate and the economy in general. The economists, David C. Ling and Milena Petrova, as well as EY, identify the following potential adverse conditions from repeal:
- reduction in commercial real estate prices,
- decrease in transaction volume,
- decrease in ancillary business income,
- reduction in re-investment,
- increase cost of capital,
- increase use of leverage,
- less productive deployment of capital
- increase in holding periods,
- decrease in real estate market liquidity, and
- disruption of local property markets, especially high-tax states, such as California.
David C. Ling and Milena Petrova, The Tax and Economic Impacts of Section 1031 Like-Kind Exchanges in Real Estate, September 2020.
Repealing Section 1031 would have the greatest adverse impact in high-tax states. California dominates all the other states when it comes to number and dollar value of exchanges. Clearly, a real estate recession would be on the horizon if Section 1031 were repealed.
In 2015, EY concluded that repeal of Section 1031 actually would reduce federal tax revenue and produce a $13.1 billion decline in the long-run GDP.
It is important to note that tax deferral under Section 1031 is not a free lunch; there is a tax price to be paid for the benefits:
- reduced depreciation deductions,
- increased capital gains on later sale, and
- increased depreciation recapture on later sale.
The statistics show that most exchangers pay some tax in connection with their exchanges. And approximately 63% of the value of immediate tax deferral is eliminated by reduced depreciation deductions on the replacement property and increased capital gain and depreciation recapture taxes on sale of the replacement property, according to the Ling and Petrova study.
Also mentioned in the study, Marcus & Millichap Research Services estimates that approximately 23 percent of all transactions they brokered in 2017 to 2019 involved a buyer completing an exchange. The exact number is unknown but clearly exchanges represent billions of dollars of transaction value every year.
The data confirms that exchanges are not predominately used by large institutional investors and that repealing 1031 would primarily hurt small investors in local markets. While all types of people and legal entities use 1031, the largest number of exchangers are “regular folks.” Real estate is still a very localized business and only 5 percent of real estate nationally is owned by corporations, according to the National Association of Realtors. Approximately 73 percent of all exchangers were individual taxpayers, based on a review of data from the Treasury on Form 8824 reporting exchanges in 2013 (the latest year available), the Ling and Petrova study states.
Also, the median sales price is only $500,000 for properties exchanged in 2018 and 2019, as reported by a national qualified intermediary. The statistics show a large number of small transactions, including single family, modest multifamily and other properties across the country in which the value of the properties is relatively low, as mentioned in the Ling and Petrova study. The data demonstrates that exchanges are not predominately used by large investors and that repealing 1031 would primarily hurt small investors.
Ling and Petrova conclude that:
[a]lthough the present value of tax revenue losses associated with real estate like-kind exchanges is relatively small in magnitude, the elimination of exchanges would nevertheless disrupt many local property markets and harm both tenants and owners. Overall, our analyses suggest that the cost of Section 1031 like-kind exchanges to the U.S. Treasury is overstated, while benefits to investors, local real estate markets and economic activity are over overlooked.
Repeal of 1031 Would Result in Harmful “Lock-in” Effect. A downside of repeal is the “lock-in” effect, where property would be held essentially forever and not exchanged for more desirable replacement property. Rather than selling an inferior asset and reinvesting in a more productive asset under 1031, investors with accrued capital gains would continue holding the less productive asset to avoid taxes, as stated in the Ling and Petrova study. This exacts a toll on the economy as well as on taxpayers. By eliminating lock-in effects, a fluid market encourages redeployment of capital (i) to better uses, (ii) in more desirable locations, (iii) with efficient upgrades that expand the productivity of buildings and facilities, and (iv) generates more income and jobs. An active real estate market also produces a spillover effect from substantial downstream transactional activity in the service industries, such as title insurance, mortgage lending and construction plus legal and accounting services. In this way, a fluid real estate market drives the economy, creates jobs and increases the tax base in a manner that offsets the governmental cost of the tax deferral.
The economy would be severely harmed from the repeal of 1031. According to EY, there would be a $13.1 billion decline in long-run GDP and federal tax revenue would be reduced. This conclusion is at cross purposes with the Biden Plan’s goal of raising revenue.
1031 Exchanges Generate Substantial Indirect Taxes
A number of factors offset the taxes deferred in an exchange and should be considered in the overall governmental “cost” of Section 1031:
Replacement property from exchanges generates large amounts of ordinary taxable income. Section 1031 provides for “carry over” tax basis, which means that exchangers typically have a very low tax basis in their replacement property. Because of the low tax basis, annual depreciation deductions are reduced dramatically. This means that future rental income from the replacement property will be largely taxable as ordinary income without much offset from depreciation deductions. Thus, instead of generating one capital gain at low capital gains tax rates, exchangers will generate substantial ordinary income taxable at ordinary income rates for the life of the investment and will owe a large capital gain and recapture tax on sale of the property.
Substantial ordinary taxable income comes from ancillary fees and salaries. There is a multiplier effect from substantial taxes on ancillary income from real estate industry participants, such as qualified intermediaries, title companies, escrow companies, CPAs, lawyers and mortgage lenders.
Exchanges generate substantial state and local real estate and transfer taxes. Even though income taxes are deferred under 1031, real estate acquired in exchanges typically is marked to market on a regular basis for purposes of local tax assessments, thereby increasing state and local real estate taxes. In addition, real estate exchanges generate substantial transfer taxes to local governmental authorities.
Most exchanges include an element of taxable gain. It is common for an exchanger to recognize some gain in their exchange transaction from cash boot received or debt reduction.
And most replacement property is sold on a taxable basis in the near future. Most exchangers will sell the replacement property on a taxable basis in the near future, so the deferral typically is fairly short lived.
Impact from Repeal of 1031
Many real estate owners and operators would hold their real estate investments forever; instead of selling at the optimal time, many would refinance over and over and over. No longer would properties have the potential to reach their highest and best use.
The Biden Plan is vague. It would end nonrecognition under 1031 for taxpayers with income in excess of $400,000.
Is this $400,000 of taxable income? Does the $400,000 threshold include the gain sought to be deferred from the exchange? No one knows.
The adverse impact of repeal would be compounded by other parts of the Biden Plan:
- tax capital gains as ordinary income for high earners,
- increased ordinary income tax rates and capital gains rates for high earners, and
- eliminate the step up on death (would end “swap till you drop”).
Elimination of 1031 could result in:
- reduction in commercial real estate prices,
- decrease in transaction volume
- reduced ancillary income,
- reduced re-investment,
- increase in the cost of capital,
- greater use of leverage,
- less productive deployment of capital increase in holding periods,
- decrease in market liquidity, and
- disruption many local property markets, especially high-tax states, such as California.
The Tax Reform Act of 1986 adopted the passive loss rule and other provisions that put the real estate industry in a tailspin for nearly a decade. Repeal of Section 1031 has the potential to do the same.
The Biden Plan was promulgated pre-COVID. It is important to note that in post-COVID, the negative economic impacts would be magnified.
The Joint Committee on Taxation, using “static” numbers, estimates that $9.9 billion in tax revenue was lost in 2019, which increases to $51 billion from 2019-2023. Actually, the cost to the Treasury is relatively small. Ling and Petrova estimate that the present value of the loss is much less.
It is critically important to note that the Joint Committee’s numbers are “static;” they erroneously assume that every 1031 exchange would be structured as a taxable sale and the repeal of 1031 would not negatively impact real estate transactional activity, prices, economic activity, or wages earned by real estate participants. However, in the absence of 1031, it is obvious that a large number of real estate owners would delay sales or engage in alternative disposition strategies, such as investing in qualified opportunity zone funds, UPREIT transactions or installment sales.
These “behavioral responses” would dramatically reduce the projected tax revenue. Ling and Petrova conclude that elimination of 1031 would likely lead to a decrease in transaction activity in most CRE markets as well as price declines in some markets, at least in the short run. These price declines would be more pronounced in states with high income tax rates. Elimination would also likely produce a decrease in capital investment on acquired properties, an increase in investment holding periods, and an increase in the use of leverage to finance acquisitions. Overall, our analysis suggests the cost of like-kind exchanges to the U.S. Treasury is likely overestimated, while their benefit to small investors and to local CRE markets are often overlooked… Although the present value of Treasury tax revenue losses associated with real estate like-kind exchanges is relatively small in magnitude, the elimination of exchanges would disrupt many local markets and harm investors.
Reasons to Retain Section 1031.
- 1031 is used by, and benefits, a broad spectrum of taxpayers
- economic studies have proven that exchanges stimulate the economy
- tax is paid on 88% of exchanges
- 1031 reflects sound policy– not to tax unrealized gains;
- encourages (tax-generating) transactional activity, and
- encourages capital formation – increases capital investment in the replacement property
- preserves scarce investment capital
- permits businesses to relocate to better locations
- permits the exchange of older assets for more efficient assets
- reduced loan-to-value that reduces risk
- results in shorter holding periods
- provides a major source of revenue for states and localities
- creates jobs from upgrades and capital improvements
Ling and Petrova. In addition to these positive attributes of Section 1031, some taxpayers view an exchange like “forced savings” that creates a compulsion to remain invested and not to cash out or use the money for discretionary purchases.
Section 1031 encourages real estate ownership and that results in substantial job creation. According to the Bureau of Labor Statistics, the real estate sector employed approximately 1.7 million Americans in 2019.
According to Ling and Petrova, by deferring taxes, many investors acquire larger properties, upgrade properties, and make capital improvements, which create jobs and add to the local government tax bases, which represent a major source of revenue for states and are the largest source of tax revenue for localities.
Exchanges permit investors to diversify their real estate holdings. Also, exchanges improve the marketability of highly illiquid commercial real estate. According to Ling & Petrova:
This increased liquidity is especially important to the many non-institutional investors in relatively inexpensive properties that comprise the majority of the market for real estate like-kind exchanges.”
Many real estate owners and operators would hold their real estate forever; instead of selling at the optimal time, many would refinance over and over and over. For example, DST properties typically have a holding period of up to 10 years, after which the DST properties are to be sold and the proceeds returned to the investors. If 1031 were repealed, many sponsors would be likely to work with their investors to consolidate the properties in an UPREIT or holding company structure for efficiency and to refinance the properties over and over again. This would result in the properties essentially being held forever, even though the stated holding period was 10 years. This is another illustration of the “lock in” effect.
Most REITs use exchanges to fine-tune their portfolios. REITs must distribute 90% of their REIT taxable income. Elimination of 1031 would make it much more difficult for REITs to adjust their real estate portfolios without distributing the proceeds to their stockholders.
Section 1031 has been in the line of fire before, from both sides of the aisle:
- 1986 – Ronald Reagan
- 2013 – former Senate Finance Committee Chairman Max Baucus
- 2014 – former House Ways and Means Committee Chairman Dave Camp
- 2016 – Republican House Ways and Means Committee proposed complete elimination of 1031 as a pay for broad asset expensing
- 2016 – Obama administration’s budget would have capped nonrecognition at $1 million per year, and
- 2020 – Biden Plan has a $400,000 limit.
It is interesting to recall that as a part of the Tax Cuts and Jobs Act of 2017, the Republican House Ways and Means Committee proposed the complete elimination of 1031 as a pay for broad asset expensing (100% write off). The real estate industry lobbied and explained the many virtues of 1031; the proposal was withdrawn.
The Internal Revenue Code is extremely complex; many provisions are interlinked and interconnected. It takes substantial time for the Joint Committee on Taxation to score the revenue impacts of proposed tax law changes; then to compute the revisions; followed by arm twisting, etc. Whose ox is being gored? And more horse trading, followed by new tax computations. This is difficult work and takes time.
Tax Reform Act of 1986; next, Tax Cuts & Jobs Act of 2017 – over 30 years.
Tax Cuts and Jobs Act took a year to pass with Republican President, House & Senate.
Tax reform is frightfully difficult to implement and takes a great deal of time. The changes have to be run through the Joint Committee on Taxation for scoring; revised numerous times and, then, the lobbying begins. I would not look for any substantial rewriting of the tax code for at least a year, most likely not until 2022.
Transition Rules. It is customary to provide “transition” or “binding contract” rules when the tax code is revised. Transition rules are intended to provide fair notice to taxpayers who acted in good faith on current law in entering into contracts and transactions. This could take the form of a transition rule – exempting exchanges before a given date – or a binding contract exception – exempting exchanges that were under binding contract before a given date. But fairness is not required in the legislative process and no assurance can be given that the Biden Plan or other future legislation impacting Section 1031 would have any transition rules.
Stay tuned for part three…
Louis Rogers is the founder and CEO of Capital Square, one of the leading sponsors of 1031 exchanges and other tax-advantaged real estate investment programs. A former partner at the Hirschler Fleisher law firm, he is an acknowledged expert on the legal history and application of Internal Revenue Code Section 1031. His guest submission on the potential threat to Section 1031 will be presented in three parts. Opinions expressed by Mr. Rogers are his own and not necessarily reflective of those held by the editorial staff of The DI Wire.