June 2021 Edition - What’s Happening with the 1031 Like-Kind Exchange Program?
The IRC Section 1031 Like-Kind Exchange program is a true government success story. Created in 1921, this 100-year-old program, has assisted a multitude of American investors from large to small. The program has also been of significant value to the economy in general by creating job opportunities and a more stable economic environment. The program is currently at risk because the Biden administration aims to repeal it.
According to a recent economic impact analysis of 1031 exchanges by the multinational professional services firm Ernst & Young Global Limited (Ernst & Young) commissioned by the Section 1031 Like-Kind Exchange Coalition, 1031 exchanges in 2021 are expected to support an estimated 568,000 jobs and $27.5 billion in annual labor income, as well as contribute $55.3 billion to the U.S. GDP. The Section 1031 Like-Kind Exchange Coalition includes a group of about 30 real estate industry associations, leading efforts to educate legislators about the benefits of rewarding investment risk, as well as the potential unintended consequences of the proposed changes to tax law. The Coalition and the Real Estate Roundtable (a non-profit public policy organization based in Washington, D.C. that represents the interest of the real estate community by focusing on policy areas governing tax, capital and credit, the environment, energy and homeland security) strongly supports the bold actions the current administration is taking to finance infrastructure needs, expand the economy, and promote job growth. However, there is concern that many of the tax proposals accompanying the American Families Plan will, “reduce economic activity, impede job growth and diminish opportunities for startup businesses and those less advantaged.”
Congress is expected to address the proposed tax reform this fall. Anthony Chereso, president and CEO of the Institute of Portfolio Alternatives (IPA) an organization that provides national leadership for the Portfolio Diversity Investment Industry (PDI), is making sure that members of Congress are, “provided with the right information so that when they are making decisions on how to support the American Families Infrastructure Plan, they are supporting it in a way that doesn’t degrade our economy but actually stimulates our economy.” He goes on to state that, “we have to get away from the conversation that this (the 1031-Exchange program) is a tax loophole,” and emphasize that it is a tax law that has been around for 100 years, and is intended to create transaction momentum in the commercial real estate marketplace and to stimulate investment and bolster the economy.
Current Tax Reform proposals emanating from Congress and the Administration make reference to the notion that the “sole” reason for the enactment of IRC Section 1031 was for “administrative convenience, “ and that this no longer exists. Therefore, the repeal of 1031 like-kind exchange is warranted. This revisionist history is untrue.
The primary purpose of the statute providing for like-kind exchanges of property has always been to permit taxpayers to maintain investments in property without being taxed on theoretical (i.e. “paper”) gains or losses during the course of a continuous investment.
The second primary purpose of the statute is to encourage the exchange of property, thus promoting transactional activity as dictated by prudent business decisions based upon changing circumstances. Section 1031 thus provides a solution to the problem of a taxpayer who is unable or unwilling to sell investment property because of the burden that capital gains and recapture taxes would place on the taxpayer’s cash flow and net worth. This purpose also speaks to the economic stimulus created by the 1031 incentive to reinvest and expand holdings within the United States. This later benefit has even greater importance in today’s global economy than it did 100 years ago when the statute was enacted.
In a letter to The Honorable Janet L. Yellen, Secretary to the U.S. Treasury, from the 1031 Like-Kind Exchange Coalition dated March 16, 2021, the Coalition stated, “Like-kind exchanges of real estate under section 1031 of the tax code support job growth and investment; the health of U.S. commercial real estate and real estate markets; and the preservation of family-owned farms, ranches, and forestland. Communities and nonprofit organizations use like-kind exchanges to conserve land for the benefit of the public and future generations. Gains reinvested in new property through an exchange create a ladder of economic opportunity for small and minority-owned businesses and entrepreneurs and generate much-need tax revenue for States and localities. Also, like-kind exchanges increase the supply of affordable rental housing by filling gaps in housing supply not covered by other incentives. For these reasons, and those described below, like-kind exchange will continue to contribute significantly to the Nation’s economic well-being and help us recover more quickly from the pandemic.”
The letter goes on to point out how like-kind exchanges:
• Accelerate our economic recovery from the pandemic by preventing real properties from languishing, underutilized and underinvested.
• How the like-kind exchange code has been narrowly tailored and well-designed over the past 100 years to accomplish its objective.
• How like-kind exchanges help small and veteran-owned, women-owned and minority-owned businesses expand and grow.
• How like-kind exchanges are an engine of job creation by supporting 568,000 jobs generating over $55 billion of annual value added, including $27.5 billion of labor income. Employment directly and indirectly supported by exchanges includes jobs for skilled tradesmen, architects, designers, building material suppliers, movers, building maintenance and cleaning staff, security, landscapers, qualified intermediaries, real estate brokers, title insurers, settlement agents, attorneys, accountants, lenders, property inspectors, appraisers, surveyors, insurers and contractors. By encouraging the reinvestment of capital and stimulating property improvements, exchanges create a more dynamic, job-creating real estate market.
• How farmers, ranchers, and forest owners heavily rely on like-kind exchanges to combine acreage, acquire higher-grade land, mitigate environmental impacts, or otherwise improve the quality of their operations.
• How like-kind exchanges promote land conservation and environmental protection by helping land conservation organizations preserve open spaces for public use or environmental protection. Land conservation transactions often involve the exchange of environmentally sensitive areas for other less sensitive privately held property, which can be put into production.
• How like-kind exchanges help increase the supply of much needed affordable rental housing. Like-kind exchanges can fill gaps in the housing supply not covered by other incentives for the development of affordable housing.
• How states and localities depend on like-kind exchanges for tax revenue.
• How like-kind exchanges are a principal tool for retirement savings. The self-employed often own real estate as part of, or incidental to, a small business venture, such as a farm, restaurant or service business. These individuals often lack a company sponsored 401 (k) plan, and reinvesting proceeds from the sale of actively managed real estate into institutionally managed, passive interest in real estate through a like-kind exchange may be their only form of retirement savings.
• How like-kind exchanges reduce the cost of capital and make the economy more efficient. Section 1031 expands opportunities for businesses to relocate to better, more productive locations. The provision increases taxpayers ability to exchange older assets for newer assets better suited to the needs of surrounding communities and tenants.
• Like-kind exchanges result in additional federal taxes collected in the years following the exchange. Capital gains deferred in an exchange reduces the owner’s tax basis in the replacement property. This results in smaller depreciation deductions going forward. The overwhelming majority of replacement properties acquired in a like-kind exchange are ultimately disposed of through fully taxable sales. Only 20% of replacement properties are disposed of through a subsequent like-kind exchange (Ling-Petrova, Microeconomic Study, July, 2015 supplemented in August, 2017).
• Like-kind exchanges help stabilize property values and real estate markets during economic crisis. During periods of economic stress, exchanges stimulate commerce and facilitate needed price discovery when buyers, sellers or lenders are otherwise reluctant to engage in transactions.
So, if the 1031 Exchange program is working so well why change it? The current administration is on a spending spree that needs to be funded. Soon after Congress passed the $1.9 trillion American Rescue Plan Act of 2021 in March, the Biden administration proposed new tax reforms detailed in the $1.8 trillion American Families Plan. The tax code changes detailed in the American Families Plan could have a heavy impact on commercial real estate investors and the industry as a whole.
According to Forbes, individual investors and limited partnerships in the U.S. control more than $7 trillion in residential and commercial rental property. To pay for programs provided as part of the American Families Plan, the Biden Administration has set their sights on wealthy Americans and high-earning real estate investors. As a result, the tax code changes could fundamentally shift the ways in which real estate is bought, sold and developed.
The Biden Administration has called Congress to make reforms that will
• Eliminate 1031 Exchanges on Real Estate Profits of more than $500,000
• Eliminate Step-Up Basis on Inherited Property
• Increase Capital Gains Tax
• Tax Carried interest as Ordinary Income
According to Bloomberg, “President Joe Biden is pushing to close tax breaks that helped his predecessor amass a fortune.” The Administration considers the 1031 Exchange program when coupled with the Step-Up Basis on Inherited Property to enable real estate investors to forgo capital gains taxes entirely and allow family dynasties to pass on riches to heirs virtually tax-free. Tax law professor Mitchell Gans of Hofstra University supports the Biden Administration position by stating that “disproportionately, the benefit goes to wealthy people as most Americans of modest means can’t afford to invest in real estate to begin with.”
Additionally, what the administration is overlooking is that if the program is terminated, the multifamily transactional volume will tumble as more investors will sit on their assets, negating any of the taxable gains that are hoped to be realized at the point of sale. If investors sit on the sidelines it will impact supply and demand. It will likely impact cap rates across the board and result in a market slowdown.
A large portion of the economic impact will stem from a slowdown in the number of investors who will no longer be motivated to move capital into property renovations or adaptive reuse opportunities to defer taxes. While the impact on total housing supply is unknown, the quality of housing could certainly suffer with 1031s playing a big role in incentivizing property renovation deals and value-add purchases.
It is a misconception that the end of the 1031 program is an elimination of an elite tax break for the wealthy. Experts suggest small-time and entrepreneurial-minded investors will end up taking a more detrimental loss to their planned retirements portfolios.
“Just-In-Case You Missed It” is a monthly letter prepared for multifamily owners and prospective owners. It is a compilation of multiple articles from multiple sources or a reprint of an article from a specific source (source credit given). Its purpose is to present both facts and opinions that may influence our multifamily business in the Southeastern U.S. If you have any questions and/or would like to discuss any of the comments above, my conclusions or your multifamily business, please contact me at your convenience. I can be a valuable resource to you without adding expense to your budget. I look forward to speaking with you and having an opportunity to meet with you. I am always at your disposal to assist you with your multifamily business. If you would like to review previous editions of my monthly “Just-In-Case You Missed It” letter they are posted on my website, www.rickbakermultifamily.com.
Respectfully,
Rick
G.F. Rick Baker, CCIM
Multifamily Specialist/Investment Advisor
www.RickBakerMultifamily.com
2504 Tinderbox Ln.
Greensboro, NC 27455
Cell: 336.549.6083
Email: rickbakermultifamily@gmail.com
Administration critics of the 1031 program say the program has strayed far from its original purpose and that repealing it could add $19.6 billion in tax revenue over 10 years. This is a significant amount of money but is an insignificant amount when compared to the estimated 568,000 jobs and $27.5 billion in annual labor income, as well as $55.3 billion to the U.S. GDP for 2021 alone generated by the program.