AUTHOR: Alfred DiNicola, CCIM
There will be untended outcomes if the 1031 exchange is altered. Many individuals as well as real estate broker/agents may not have followed the potential elimination of the use of Section 1031 of the Internal Revenue Code. While the future Biden administration may be targeting certain high net-worth investors this could negatively impact individual investors, small business owners, and the overall economy.
Biden proposed a package (during his presidential campaign), that includes using the estimated $50 billion in tax revenues generated from eliminating 1031 exchanges, for investors with a net worth of over $400,000. The purpose is to pay for improved childcare and healthcare for seniors. The $400,000 level is an unclear number and subject to interpretation. Few if any news outlets questioned or challenged Mr. Biden on the full effects of the elimination. We have participated in conference calls including industry experts and have identified many reasons why this is not a quick stroke of the pen solution.
There a few people who would argue that childcare and healthcare for seniors are not important. Assisting these group hardest hit by the COVID 19 pandemic is important. Biden’s economic recovery plan may have many initiatives, but there may be better funding sources rather than the elimination of the 1031 exchange.
Personally, I grow tired of legislators who reference the 1031 exchange as a “loophole”. There are long term benefits from 1031 exchanges by deferring capital gains and depreciation taxes. However, the economy realizes far-reaching, long-term benefits from the process as well. Section 1031 of the Code is an engine for growth that pays for itself many times over. This includes jobs, taxes, increased revenue to states and municipalities and potential financial security for the individual investor.
In my opinion simply looking at how to capture the deferred taxes politician may be oversimplifying the far-reaching benefits. Politician may harness a myopic view and ignore all the other benefits that have far reaching effects downstream and upstream. Many experts have opined that commercial real estate may drop 15-20% if the 1031 is eliminated. Naturally there are those who may challenge a drop in commercial real estate. However, the pandemic is already affecting real estate values in certain section of the country. That is another topic for in-dept analysis.
It’s not just a paper transaction it is “Jobs, jobs, and more jobs”
The IRS 1031 Exchange rules do involve documentation and paperwork as well as strict time requirements. The impact and scope of the exchange reaches beyond a single investor looking to defer tax payment. Investor often use the funds that may have gone to pay taxes to make upgrades to the property. The investor may diversify their holdings and improve the community. Once a property is acquired there may be additional spending on building supplies and improvements that funnel money back into the local economy as well as sales tax revenue. As properties sell in local municipalities the increased assessed value adds incremental tax revenue to the local budgets and economy.
The impacts go beyond just the materials. The upgrades may include the services of architects, contractors, electricians, plumbers, laborers, and others. There is also the need for all the services that are utilized to complete the exchange including qualified intermediaries, lawyers, appraisers, and escrow agents. All pay federal and state income taxes.
Research has shown there would be a clear negative impact to the economy should 1031 exchanges be eliminated. 1 A 2015 Ernst & Young study found that repealing 1031 exchanges could shrink the economy by more than $13 billion, discourage investment, and lower tax revenues. Municipalities that would rely on the increased tax revenue could be the most effected.
Let’s pause to understand how far 1031 exchange benefits reach
As mentioned, before we need to refrain from looking myopically at grabbing the immediate tax gain missed during a real estate transaction. This is part of the fight that involves the lens through 1031 is viewed. 1031 has been around for 100 years and needs a broader view to understand why this statue has been around so long. Facts are that Individual investors and small businesses are among the biggest users of 1031 exchanges. Using a 1031 could help to a secure financial future, a key financial planning tool, and an income stream for retirement.
Let’s talk about the farmers
Many farmers have land holdings that have been in the family or generations. Often the farmers are a forgotten segment of 1031 exchangers. They are in a unique position to use the provision to secure their futures and assist their communities. Farmers are able to sell land that is no longer productive for farming to aid conservation efforts by selling easements that restrict crop production or other farming activities. They can also exchange property for non-farm property investments to protect multi-generational wealth. If the farmers sell the land for development, there is an immediate increase in tax revenue with a new development. Under all is the Land! This may be the only asset the farmer owns.
Education before action on 1031 exchanges
We urge all stakeholders to take an in-depth look at the 1031 exchange and fully understand the value of this 100-year-old section of the tax code before taking any action.
On the surface there is the ability to defer taxes by reinvesting the proceeds from the sale of one property into another. This provides a multitude of positive outcomes including the investors flexibility to spend more on property improvements, secure the income needed to last through retirement, accumulate generational wealth. There are also the facts that the 1031 exchange process generate jobs, and fuels economic growth. This may be the wrong time to consider eliminating certain property owner’s ability to perform a 1031 exchange. The economy is still struggling in the midst of a pandemic. While programs that help children and seniors have universal appeal, funding them through the elimination of the IRS Section 1031 exchange has the potential to provide a short-term bump while unintentionally limiting long-term prospects.
1 Ernst & Young 2015 study results: www.1031taxreform.com/wp-content/uploads/…