A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to defer paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value. There are a number of timing requirements for the exchange to succeed.
This program was set up to promote investment into commercial real estate, which is imperative for business and job development. It incentivizes investing in the United States real estate market and can only be taken advantage of if you buy a more valuable property.
While there are a lot of rules of what qualifies as a 1031 Exchange and a process that must be followed in order to avoid capital gain tax, here is the simplified process in how to participate in an exchange:
Figure 1: Graphic taken from http://www.fordinvestmentproperties.com/1031-exchange.html
If you are participating in a 1031 exchange, you will need a qualified intermediary. KW Commercial has had great success working with Asset Preservation, Inc (API). Established in 1990, API is a recognized national leader in 1031 exchange companies and has successfully completed over 180,000 IRC Section 1031 exchanges.
Why is 1031 Exchange important?
While most people will not participate in a tax deferred exchange like this, it does affect everyone in the US job market. Programs like this incentivize investors to buy and fix up commercial properties, creating places to open businesses and create jobs. It also may create higher sale prices in the commercial real estate market. If someone decides not to participate in a 1031 exchange, they would pay capital gains taxes and increase tax revenue to the federal coffers. Keep in mind, the 1031 Exchange is a federal program and does not affect state taxes. While some states offer similar incentives to the 1031, states do receive tax money on the capital gains and real estate transfer taxes in a 1031, which are not insignificant.
In a recession, programs like this help spur economic growth. Removing a program like this would likely decrease commercial development, which would cause further job loss, more businesses to find it difficult to stay open, and decrease viable commercial space options. On the flip side, in a good economy, it creates the movement of money, which creates more jobs, which creates more tax revenue from other sources.
Eliminating this program would likely lead to less investment in real estate, more money being stored in other tax havens (not helping to grow the economy through reinvestment), and less investments in commercial real estate as large gains on real estate would cost owners greatly in capital gains taxes.
Why would ending this program not produce results some policy makers think it would?
The 1031 has been the target of legislators on several occasions through the last number of years. Senator Biden’s proposal would be devastating to the real estate market, especially after the hits taken because of the Corona Virus over the first half of 2020. To date, the legislature has recognized that this program is a stimulus to the economy that keeps investors in the real estate market longer and moving from property to property, trading up to bigger properties as they go. The 1031 Exchange has been around since 1921 and survived many attempts to end it. Usually on a bi-partisan basis it is kept in the code.
The Democratic presidential nominee proposed eliminating 1031 “like-kind” exchanges for investors with annual incomes greater than $400,000, as part of his plan to finance $775 billion in government spending on child care and care for the elderly over the next 10 years. Biden said that his proposal, which would also limit investors’ ability to offset their income tax bills from real estate losses, would add millions of “shovel-ready” jobs to the economy – particularly for women and minorities. It would be interesting to see the economics of the concept as it does not appear to hold water within most economists circles; the proposal was very weak on details.
“The way we pay for it is by rolling back unproductive tax cuts: some of the $2 trillion tax cut the president put through. Closing loopholes. Unproductive tax cuts for high-income real estate investors while ensuring high-income earners pay their tax bills.”
Biden during a speech in Delaware – July 16, 2020
Most of the exchanges are with small to medium business owners that use this as a tool to move their business up as it expands. Yes, there are a lot of larger investors that take advantage of the program as well. According to an article in Bloomberg, the 1031 strategy is projected to save investors $51 billion between 2019 and 2023, based on Congress’s Joint Committee on Taxation assessment. Bloomberg also stated, for their part, that real estate investors say that like-kind exchanges improve liquidity in the market. Eliminating the benefit would reduce the number of transactions that could generate tax revenue. They also point out that the industry is already reeling from the fallout of the Covid-19 pandemic, which has shuttered hotels and shopping malls and led property owners to skip payments on billions of dollars of debt.
“I am not sure kicking our critical industry when it is already down in the dumps makes a lot of sense,” said Bruce Stachenfeld, the chairman of Duval & Stachenfeld LLP, a real estate-focused law firm in New York. “I wonder if it might make more sense to pick an industry that is doing really well right now to pay for these programs.”
The 1031 Exchange is a pro-business type program that, if altered, would almost certainly have unintended consequences. It is highly likely, that removing it will not increase tax revenue, and could have devastating consequences. Bi-partisan support is needed to keep this program going and, in the upcoming congress bi-partisan, it may not be something that exists any longer.
The only promise that we, the writers, have, is that while we’re both commercial brokers, we come from different generations, different political backgrounds, different income levels, and many other differences, and we both understand that business need programs like this to maintain a healthy environment in the economy.
So what is the bottom line? What is the real, deal? Time will tell. History has a habit of taking the unaware by surprise and the unprepared by storm.
Biden’s Tax Plan & Effects on Real Estate Industry
Biden Attacks $50B Real Estate Tax Break in Jab at Trump
– Written by Dave Garvey & Ethan Ash
– Statistics taken from ‘The Real Deal: New York Real Estate News”, Bloomberg.com, Ford Investment Properties