TABLE OF CONTENTS
- What is a 1031 Exchange?
- What types of property can be used in a 1031 Exchange?
- Who uses 1031 Exchanges?
- Who's affected by 1031 Exchanges?
- What are the benefits of 1031 Exchanges?
- The proposed elimination of Section 1031
- What are the negative impacts if 1031 Exchanges are eliminated?
- What's the economic trickle-down effect of the elimination of 1031 Exchanges?
What is a 1031 Exchange?
The name is derived from Section 1031 of the Internal Revenue Code. The 1031 exchange allows a property owner to sell a property without having to initially pay the taxes on any proceeds from that sale, as long as those proceeds are being reinvested into a similar property. These are also referred to as a like-kind exchanges, due to the fact that property owners are essentially “exchanging” commercial real estate or personal property for a similar kind of property. The use of 1031 exchanges is a driving factor in continued investment in commercial, agricultural, and rental real estate, as well as many other industries.
What types of property can be used in 1031 Exchanges?
In order for a 1031 exchange to take place, both the property being sold and the property being purchased must meet certain requirements. Each of the properties being exchanged must be used in a trade or business or for investment.
The tax code excludes some property even if the property is used in trade or business or for investment. These excluded properties generally involve stocks, bonds, notes, securities and interests in partnerships.
Property used primarily for personal use, such as a residence or vacation home, does not qualify for like-kind exchanges.
In real estate, like-kind property is generally defined as real property located in the United States. Most real estate will be like-kind to other real estate. For example, a single-family rental can be exchanged for a duplex, raw land for a shopping center, or an office building for apartments.
Section 1031 is typically associated with the real estate industry, although it also applies to personal property, such as gold coins, artwork, aircrafts, commercial fishing boats, and a variety of other items.
Who uses 1031 Exchanges?
There are a number of industries that are active in using 1031 exchanges, with the most common of those being real estate and equipment/vehicle rental and leasing industry. In fact, of the nearly $500 billion in annual real estate transactions, and estimated 30% are done using 1031 exchanges.
In addition to those, the Ernst & Young study “Economic Impact of Repealing Like-Kind Exchange Rules” notes the transportation and warehousing industry, mining and resource extraction, construction, and services industry round out the top-5 sectors based on percentage of fair market value of property received in like-kind exchanges.
Other industries using like-kind exchanges include:
- Agriculture, forestry, fishing, and hunting
- Finance and insurance
- Wholesale trade
- Retail trade
Who’s affected by 1031 Exchanges?
While 1031 exchanges are used by a select number of industries and professions, their implementation has a trickle-down effect on a vast number of sectors of the U.S. economy. The deals created by 1031 exchanges help fuel activity by keeping mortgage brokers, lenders, and banks busy with more deals and with origination fees. They keep appraisers, surveyors, phase one companies, inspection companies, and many others busy as well. Not to mention the fact that these deals create significant opportunities for real estate developers, real estate agents, contractors, subcontractors, and a variety of other sectors that are responsible for creating a healthy real estate market.
What are the benefits of 1031 Exchanges?
The use of 1031 exchanges provide an array of benefits to those that use them, as well as stimulating the economy and those industries involved in the trickle-down effect. Some of the most important advantages of 1031 exchanges include:
- Deferring Capital Gains Taxes
This allows property owners to exchange properties without facing the burden of heavy capital gains taxes. Investors are then able to put 100% of capital towards future investments, as opposed to taking a significant financial hit upon selling a property.
1031 exchanges have long been used as a means of wealth accumulation. By deferring capital gains taxes and keeping 100% of net proceeds, investors use this as an opportunity to trade up in real estate value, and ultimately increase cash flow and net worth.
- Encourages Reinvestment
Related to the deferring of capital gains taxes and wealth accumulation, 1031 exchanges tend to lead to greater reinvestment into additional properties. Releasing property owners from the burden of large capital gains taxes, and providing a means of wealth accumulation, 1031 exchanges provide security and interest from property owners to reinvest in additional assets.
- Allows for Property Improvements
By providing property owners a means of wealth accumulation, 1031 exchanges also help facilitate property improvements. The increased cash flow allows investors to put money back into their properties, which ultimately has a trickle-down effect on real estate values and the surrounding communities.
- Easily Consolidate
The use of like-kind exchanges provides property owners the ability to consolidate their ownership of multiple properties into a single, possibly more manageable property.
- Easily Diversify
Simply put, 1031 exchanges allow property owners to reinvest money into new properties that may help diversify their portfolios. Due to the fact that multiple properties may be acquired through single exchanges, investors are able to reduce their risk by expanding into different property types more easily.
- Promotes Job Growth
The use of like-kind exchanges promotes job growth through retail expansion, construction increases, property improvement requirements, as well as increased activity in a whole host of additional industries that are involved in the 1031 exchange process.
- Stimulates Economy
The composite of many of these elements of 1031 exchanges is that they play a significant role in stimulating the economy. They allow for continued re-investment into property and deployment of capital into the market, which in turn drives activity in multiple industries, creates jobs, and boosts the overall economic GDP.
(*Note: Since the original posting of this content, The Tax Cuts and Jobs Act was signed into law and took effect on January 1, 2018. Broadly put, this bill preserved Section 1031 of the tax code.)
The Proposed Elimination of Section 1031
Section 1031 exchanges have been on the government’s chopping block for years. Lawmakers are proposing a tax reform blueprint that would bring sweeping changes to the tax code for the first time since 1986. The overarching theme of the proposed plan is to create a pro-growth tax code. But a lot of people in the commercial real estate industry are worried about the damage this overhaul will have on the industry due to the proposed repeal of Section 1031.
The main push by legislators has generally been that the elimination of Section 1031 will help to offset individual and corporate tax cuts.
What are the negative impacts if 1031 Exchanges are eliminated?
The commercial real estate industry is staring down devastating effects if tax reform eliminates 1031 exchanges. This could cause a decline in real estate values, long-term increases in tenant rents, increases in debt, and higher tax burden. Additionally, we’d likely see a slower rate of investment, reduced transactional activity, and a host of other effects that could spell doom and gloom for the industry and the entire economy.
Over a 10-year span, we’re talking up to an estimated $131 billion decline in U.S. GDP, according to a 2015 analysis by Ernst & Young. The same study estimates that investments would drop by $7 billion, and labor income would fall by $1.4 billion in the long-run.
In the study “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate” by Dr. David Ling and Dr. Milena Petrova, they note the most drastic impacts of the repeal of like-kind exchanges as:
- Taxes would increase for thousands of commercial property owners
Typical commercial property owners would see a rise in their effective tax rate (including rental income and gain; nine-year holding period) from 23 percent to 30 percent.
- Property values would drop
In local markets, and states with moderate levels of taxation, commercial property prices would need to decline 8 to 12 percent in order to investors to maintain an equal level of return.
- Rents would increase
Rents would have to increase from 8 to 13 percent in order for new construction to be financially viable. The higher rents would reduce affordability of commercial space on all fronts.
- Real estate sales activity would decline
Property holding periods would increase on a majority of properties. Ling and Petrova noted that an analysis of 336,572 properties between 1997 and 2014, those involved in like-kind exchanges had significantly shorter holding periods.
The belief by those supporting the elimination of 1031 exchanges is that the increased capital gains tax revenue will help offset the proposed personal and corporate tax breaks. However, as the Ernst & Young study notes, “ its repeal increases the tax cost of investing by more than a corresponding revenue neutral reduction in the corporate income tax rate and reduces GDP in the long-run.”
What’s the economic trickle-down effect of the elimination of 1031 Exchanges?
There a vast number of industries and professions that would be adversely impacted by the repeal of Section 1031. As previously discussed, 1031 exchanges are used by a number of industries from real estate, to equipment and vehicle rental, to construction.
According to Ernst & Young, the industries with the most concentrated impact are specialty construction trade industry, which is estimated to contract in total by $8 billion in output annually in the long-run. Additionally, the residential and non-residential real estate industries are also estimated to contract by $8 billion annually in long run.
The elimination of this portion of the tax code will create a trickle-down effect on the entire economy. The deals created by 1031 exchanges help fuel activity by keeping mortgage brokers, lenders, and banks busy with more deals and with origination fees. They keep appraisers, surveyors, phase one companies, inspection companies, and many others busy as well. Ultimately, the decrease in activity is going to influence cap rates, rents, tenant expansion, and that trickle-down effect will continue.