As the presidential election season moves into full swing, a popular tax mechanism for real estate investors has found its way into the crosshairs.
Presumptive Democratic nominee and former Vice President Joe Biden recently suggested eliminating 1031 exchanges for real estate investors with annual incomes of more than $400,000 in order to help pay for a ten-year $775 billion plan that would create universal preschool, eliminate home care waiting lists for those on Medicaid and create tax credits for low-income and middle-class families to help pay for childcare, among other initiatives. He argued that investing in workers who form the “caring economy” that’s been hard hit by the coronavirus pandemic will help repair some of the fiscal damage caused by COVID-19.
“This is both a moral and economic imperative for the nation in my opinion,” Biden said at a campaign event unveiling the plan in New Castle, Delaware, late last month. “And 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.”
While he appreciates the effort to revitalize this sector of the economy, Dan Wagner doesn’t think targeting real estate investors is the right way to fund it. “While the intentions behind the plan are admirable, the means through which his campaign intends to finance this initiative are grossly misguided and need to be reconsidered,” the senior vice president of government relations at The Inland Real Estate Group LLC, a commercial real estate and finance firm based in the Chicago area, said in a statement. He added that the move “would be devastating to our economy and would ultimately hurt the very people he is trying to help.”
Also known as a “like-kind” exchange and deriving its official name from Internal Revenue Code Section 1031, the rule allows taxpayers to defer capital gains payment and recapture taxes on the sale of property by reinvesting in a new building.
The National Association of Realtors has long lobbied in support of the provision. “Some believe like-kind exchanges are used only by the super-rich and think closing this so-called loophole would create an easy pot of gold at the end of the rainbow,” Shannon McGahn, NAR senior vice president of government affairs wrote in a recent commentary in Realtor Magazine, adding that only 5% of exchanged properties are held by corporations, with the majority owned by mom-and-pop investors. “The great majority of properties now swapped under the like-kind exchange would not be sold if tax was due. Rather, their owners would continue to sit on the property, and the growth opportunity for putting the investment to better use would be wasted.”
Over the almost 100 years that it’s been around, the 1031 exchange rule has been targeted for reform many times, according to Wagner, but its effect on the liquidity of the real estate market and economy overall has kept it intact. When the idea to eliminate the 1031 exchange came up in discussions over the Tax Cuts and Jobs Act of 2017, two separate impact studies by Ling & Petrova and Ernst & Young LLP “articulated what pages of political soundbites might not have,” according to Wagner. “Elected officials quickly came to the realization that not only was the cost of like-kind exchanges to the Treasury grossly overstated, but that an outright repeal would devastate several important industries, harm the economy as a whole, and in the end cost the government in the long run.”
Wagner noted that the Ling & Petrova study underscored the temporary nature of the tax deferral, finding that 88% percent of the time, properties that are acquired as the replacement for the deferred property are disposed of in a taxable sale. It also found that buildings that were bought using this tool are on average 33% more valuable than ones they were traded in for, and that they created more jobs and physical improvements than those bought in a traditional way.
The Ernst & Young study looked at what a repeal might do. Wagner noted that it found evidence of the lock-in effect that real estate professionals worry about when it comes to repeal, reducing liquidity in the real estate market, slowing economic growth and ultimately having a negative impact on gross domestic product. Aside from the economic argument, Wagner noted that 1031 exchanges have a role to play in conservation and environmental policies. “Grants of conservation easements can be structured as tax-deferred exchanges, facilitating government and privately funded programs designed to improve water quality, reduce soil erosion, maintain wetlands and sustain critical wildlife habitat,” he said, adding that the exchanges also allow owners to replace property in sensitive areas with those that are more amenable to development.
But perhaps the most pressing reason to support the retention of this rule is related to the precarious situation that our economy is in at the moment, Wagner said. “The idea of eliminating Section 1031 would be the final straw that would break the commercial real estate markets,” he said. “It creates and preserves jobs and … is used by a broad spectrum of taxpayers, from middle class and small businesses to large enterprises, to synergistically spur on our economy.”