Introduced in the 1920s, Section 1031 like-kind exchanges (named after IRS code section 1031) allow sellers of real estate properties to defer capital gains taxes if they invest the proceeds in other investment property. Like-kind exchanges are an important part of modern commercial real estate markets, and integral to how many real estate owners plan their investments. Some lawmakers interested in comprehensive tax reform, however, have targeted Section 1031 for elimination. A recently released economic analysis provides strong support – including empirical data – for maintaining tax code provisions allowing for tax-deferred like-kind exchanges.
For commercial real estate investors, who deal with essentially long-lived capital assets, past depreciation deductions often magnify the tax impact of transferring ownership of a structure. This tax liability creates a “lock-in” effect which, in the absence of an ability to defer taxes on an exchange, would result in a reduction of activity in the real estate sector. The challenge from a public policy point of view, of course, is to show why having this ability for real estate is better for the nation as a whole than eliminating Section 1031, simplifying the code and gaining more revenue for the taxpayer.
The economic analysis, The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate, was authored by David Ling, a finance professor at the University of Florida’s Warrington College of Business and past president of the American Real Estate and Urban Economics Association, and Milena Petrova, a finance professor at Syracuse University’s Whitman School of Management. They analyzed more than 1.6 million real estate transactions over an 18-year period (1997-2014), with a combined volume $4.8 trillion of transactions.
The study, which was sponsored by a group of 16 real estate related organizations, including NAIOP, is important because it attempts to provide empirical data to inform the public policy debate. It offers support for the long-held beliefs by many in the real estate industry that without Section 1031, taxpayers would hold their properties longer and dispose of them less frequently, and be forced to rely on more debt in financing future transactions.
In short, despite the claims made by those arguing that eliminating like-kind exchanges would bring in more money to the federal government, the study shows that tax-deferral in the commercial real estate sector is temporary, leading to greater tax revenues than otherwise would have occurred because of the increased value created in real estate.
The study found that Section 1031 like-kind exchanges result in:
- Increased investment: Taxpayers who utilize a like-kind exchange on average acquire replacement property that is $305,000 to $422,000 more valuable than the relinquished property;
- Increased federal tax revenue: In more than a third of exchanges, some federal tax is paid in the year of the exchange. Thereafter, like-kind exchanges result in added revenue because of the higher tax liability associated with increased investment in the real estate asset and greater value of the property following the initial exchange;
- Less debt: In the case when the like-kind is for property that is close to or less than the original property, an exchange results in a 10 percent reduction in borrowing, or leverage, at the time of the acquisition of replacement property;
- Increased economic activity and jobs: Properties acquired through a like-kind exchange are most often the subject of upgrades, capital expenditures, and improvements, resulting in additional economic activity that leads to more jobs.
What would be the impact of repealing Section 1031, aside from increasing taxes on real estate investors? According to the study, the following would result:
- A drop in property values: In local markets and states with moderate levels of taxation, commercial property price would have to decline 8 to 12 percent to maintain required equity returns for investors expecting to use like-kind exchanges when disposing of properties;
- Increased rents: Rents would need to increase from 8 to 13 percent before new construction would be economically viable. The effects would be more pronounced in high-tax states;
- Fewer transactions: Exchanges increase liquidity in real estate markets. Properties involved in like-kind exchanges had significantly shorter holding periods than similar properties.
The biggest impact would be felt in the Western and Southwestern United States, where nearly 80 percent of all 1031 exchanges from 1997 to 2014 took place. But the effect on commercial real estate industry and the overall economy would be nationwide. The resulting negative impact upon and disruption of real estate markets far exceed the cost savings claimed by repeal advocates.
The bottom line: eliminating Section 1031 would not be smart for the taxpayer, and would be a severe blow to real estate.