Deficit spending has spiraled out of control, ballooning our national debt to over $28 trillion and counting. With another $1.9 trillion going out the door to dull the impact of Covid-19 on the economy, and an estimated $2.3 trillion infrastructure bill in the works, taxes are going to increase to cover the mounting bills. Lawmakers have many options at their disposal including raising capital gains, corporate, estate, and income taxes, to name a few. Times like these raise concern within the real estate industry that the 1031 exchange could once again be on the chopping block.
A 1031 exchange allows for the “like-kind” exchange of investment property, deferring capital gains on the sale, and effectively allowing the property owner to trade-up their asset for a larger property within a specific time period (45 days to identify/180 days to close). Celebrating its 100th anniversary since being signed into law in 1921, its specifics have undergone various changes over the years. The most recent change occurred as part of the Tax Cut and JOBS Act, excluding personal property, like aircraft and artwork, from its scope.
Detractors have argued that it is vastly used as a loophole for the wealthy, an abusive tax shelter, and unfairly gives preferential tax treatment to the real estate industry. Is this really the case, though? Lawmakers would serve the public well by educating themselves on the facts.
1031 exchanges create jobs. Exchanging property involves brokers, lenders, inspectors, appraisers, surveyors, engineers, and contractors. That is a lot of vendors who otherwise would have less work without the incentive to trade property. Wages these workers earn then get redistributed into the economy through spending on goods and services, benefiting business in the communities they live, and leading to more hiring and job creation. In a poll conducted by The National Association of Realtors, 70% of realtors said they had been involved in a 1031 transaction.
1031 exchanges increase investment in properties. Tax deferral incentives sellers to transfer property to buyers who likely intend to make improvements. Without the benefit of tax deferral to trade-up, property owners would likely avoid a large capital gain event, hoarding assets, and decreasing investment in affordable housing. These are the properties that need investment most, providing quality housing to an underserved segment of the population. Additionally, as our economy changes, retail and office space will need to be repurposed, requiring a change of hands to buyers with alternative business plans. Incentivizing sellers to trade-up benefits communities, which would otherwise have buildings riddled with deferred maintenance and vacancy.
1031 exchanges Increase local and state tax revenue. As property changes hands it will be reassessed at an increased value, leading to a higher property tax bill for the buyer. This increase in the tax base directly benefits local schools, roads, state programs, and other infrastructure.
A 1031 is not a tax break, just a deferral. The only way a taxable event is never realized through the trading of property, is if the owner holds the replacement property acquired through the exchange process until death, thereby benefiting their heirs with a stepped-up cost basis. The reality is that most 1031 exchanges are one-time events. The typical property owner would, for example, trade-up from a 4-plex to 10-unit apartment, but eventually sell the apartment, realizing a taxable event. Uncle Sam eventually get’s their take. A recent study by Ling & Petrova highlighted that 88% of real estate replacement properties acquired through 1031 exchanges are sold through taxable sales, not subsequent like-kind exchanges.
1031 Exchanges benefit retirement accounts. Most individual investor do not own physical real estate. The majority of pension funds, endowments, 401Ks and IRA accounts do hold real estate, however, in the form of real estate investment trusts (REITs). REITs benefit from utilizing 1031 exchanges, thereby benefiting their shareholders and retirement accountholders as a whole.
Conclusion
A study done by Ernst & Young brought light to the negative effects that repealing the 1031 exchange would bring. Ultimately the study concluded that businesses would be burdened with higher taxes on their transactions. This in turn would discourage investment and result in longer holding periods, subsequently having a negative effect on economic growth and a reduction in GDP.
So, what’s the chance the 1031 exchange is repealed? Zero in my estimation. If lawmakers seek re-election, regardless of party affiliation, they would be well served to continue to provide incentives that help drive investment and prosperity in this country. Upon further examination, the 1031 exchange benefits the economy as a whole. It creates jobs, encourages investment, and actually increases the tax base, supporting the current agenda in Washington. Repealing it would only provide a headwind towards this administration attaining its goals.
Do you think the 1031 is going away?