2020 election: 1031 exchange on the chopping block?
It’s the time of year when politicians are outlining their vision for the future and plans to get there. One such plan recently introduced by a 2020 presidential candidate has caused some uncertainty around the future of capital gains tax breaks through 1031 exchanges. According to various reports, Joe Biden’s latest proposal calls for phasing out the 1031 exchange program for investors making over $400,000 annually, removing a powerful incentive for continued commercial real estate investment. The tax revenue created would contribute to Biden’s $775 billion Caring Economy plan aimed to repair the fiscal damage caused by COVID-19 and help support child care, elder care and Medicare services.
The 1031 exchange, also known as a like-kind exchange, dates back to 1921 and was defined more formally in Section 1031 of the tax code in 1954. It has come under scrutiny and has been threatened to be eliminated many times in the past, most recently by Republicans in 2017, but has survived time and time again mainly because of research proving its positive impact on the economy. While on a superficial level it would seem like doing away with the 1031 exchange would accomplish the goal of boosting tax revenue, in reality, it would have far-reaching detrimental effects on the commercial real estate industry, economy and small businesses.
The 1031 exchange allows an investor to defer capital gains tax on the sale of a property by reinvesting in a new building. Currently, capital gains tax can be 15% or 20%, depending on income and tax filing status. Short-term capital gains for properties held under one year are taxed at a taxpayer’s ordinary tax bracket, which is usually at a much higher percentage. Almost every property is subject to capital gains tax if sold for more than the original purchase price. In addition, the property may be subject to the state capital gains or income tax, which is 4.63% in Colorado, around the middle of the pack.
So long as the property exchanged for, known as the replacement property or upleg, is like-kind, which can be interpreted liberally, and greater than the sale price, no capital gains are paid. There is a 45-day time frame to identify the replacement property after the sale of the relinquished, or downleg, property. Up to three candidates can be identified. The exchange period is the time frame between when the sale of the downleg property closes until the acquisition of the upleg property. It cannot exceed 180 days. There is no limit to how many times a 1031 exchange can be used by the same entity to roll gains into new properties. There are many more nuances to the process. Consulting with an accountant and qualified intermediary, who facilitates and holds funds for the 1031 exchange, are prudent first steps.
Proponents of eliminating the 1031 exchange say that it artificially inflates values due to the motivation created by a short exchange period while also providing an unfair mechanism and tax loophole for wealthy real estate investors to avoid taxes. Some counter the tax argument by stating that real estate is constantly taxed during ownership through county and municipal property taxes.
Repercussions of eliminating the 1031 exchange could have far-reaching effects on commercial real estate markets that already are suffering due to COVID-19. There could be a decrease in real estate investment, development and overall transaction volume as holding periods of property increase. Commercial real estate could become even less liquid, and the market could become inefficient. The effects of this could be lower demand and plummeting property values, essentially decreasing property taxes and revenue for local government. The slowdown could affect commercial real estate brokers, architects, civil engineers, attorneys, building material providers and contractors, to name a few sectors, while lenders, title companies and related vendors may feel less impact as a result of an uptick in refinancing.
The 1031 exchange is most frequently used by private investors and owner/users. It allows owners to better allocate resources and for the highest and best use of properties. In the past several years, office buildings have traded at record pace with new owners putting into action a plan for capital improvements and tenant amenities providing for improved buildings throughout Denver and more opportunity for tenants to get what they demand. Beyond investors, owner/users use the 1031 exchange as a catalyst to make business sense of efficiently utilizing their real estate as their business evolves. For example, a business that has outgrown a 5,000-square-foot building that it owns and occupies can purchase and move into a larger, more expensive building without incurring a capital gains tax at the time of the transaction. Not having the 1031 exchange available might negate their ability to do so or to use those funds in their business operation where they create the most benefit. That same user has more freedom to change geographic locations or diversify their holdings. In summary, the more frequent trading of properties and real estate owner’s better use of resources on the right investments in turn creates a more efficient market.
The outcome of the proposal to eliminate the 1031 exchange is unknown and could disappear quickly or continue to evolve. It is something that should be closely monitored.
Featured in CREJ’s September 2020 Office Properties Quarterly