The tax plan proposed by President-elect Joe Biden could have a major negative impact on the commercial real estate industry.
Biden’s proposal includes the elimination of like-kind exchanges, commonly referred to as a 1031 exchange, and would apply to real estate investors earning more than $400,000 annually.
Brokers and real estate lawyers say stripping away the tax deferral benefit allowed in a 1031 exchange would lead to fewer sales and far less investment in commercial property.
“That would absolutely put a halt on momentum in the investment sale arena,” said Joe Rowley, senior advisor and managing broker at SVN Realty Performance Group.
It’s a belief shared throughout the industry.
“It would have a real chilling effect on commercial real estate transactions,” said Stephen Tierney, a partner and chair of the real estate development and finance group at Woods Ovaitt Gilman LLP. “There would be less investment in commercial real estate, and owners would be more heavily leveraged because they wouldn’t have as much equity to reinvest. And it will drive prices down because there won’t be as many buyers.”
Forcing real estate investors to pay tax on the capital gains — rather than deferring that payment by reinvesting in another property — would help pay for the ramped up child care and elderly care proposed by Biden.
But while many would argue that the target of that tax revenue is surely worthwhile, the real estate industry says the 1031 exchange is the wrong place to find that money.
“The 1031 exchange incentivizes them to reinvest that money, and it increases the number of transactions,” said Matt Lester, managing partner at Caliber Commercial Brokerage. “It gets investors more comfortable to go buy something else. If it’s eliminated, it will decrease the transaction volume nationally.”
Under the current tax code, the 1031 exchange allows taxes on capital gains to be deferred if the property owner reinvests those funds in another “like-kind” property within 180 days of the realization of those gains.
Basically, this is how it works: a building owner sells a property for $1 million, $200,000 above purchase price. The owner must identify within 45 days the next property to purchase, then close on that deal within six months. There would be no tax on the capital gains as long as it was all reinvested in another property.
“It gives a little bit of an advantage to our market to keep peoples’ money invested in our market. If they eliminate it, there’s a likelihood investors will look at alternative investments when reinvesting those funds,” Lonnie Hendry, head of advisory services for CRE at Trepp, said in a recent TreppWire podcast. Trepp is a national data modeling and analytics firm concentrating on the commercial real estate markets.
The 1031 exchange was created in 1921 and over the years often has been the target of proposed tax law overhauls. It has survived every potential elimination, although the Tax Cuts and Jobs Act of 2017 by the Trump Administration did make a revision, eliminating the allowable exchange of equipment such as planes, vehicles and machinery.
The ability to defer tax on real property remains, and that perk is vital to the CRE market.
“The commercial real estate market as a whole is considered somewhat inefficient,” Hendry said on the TreppWire podcast. “It’s long-term holds; even to do a transaction takes time. There are certain things that are pretty efficient and 1031 exchange is one of those things.”
That efficiency is seen across the country, too.
“This isn’t just a big-city issue, it’s going to affect real estate everywhere in the U.S,” Tierney said.
The tax deferral is one reason commercial real estate is appealing to a certain sector of investors. Take it away and they may very well take their money elsewhere.
“I look at it as detrimental to not only the commercial real estate industry, but also the development industry,” Rowley said. “You’re going to eliminate two sales. You’ll eliminate the desire of an owner to sell a property and eliminate that owner’s desire to buy another property.”
Quite often, if not always, the new owner of a property wants to increase the value through renovation, with the expectation of increased value over time.
“The money in those sales is a long hold,” Rowley said. “The new investor is full of ideas on how to improve the investment, so they’re spending on improvements to the property.”
Therein lies part of the trickle-down effect of the 1031 exchange. Buildings usually sell for more than the previous purchase price, and certainly more than what the assessor says it is worth.
“I’ve yet to see a 1031 exchange where the building sold for less than the assessed value,” Lester said.
That means that after the sale, the assessed value goes up, which means more money in taxes, which means more money for schools, which means more teachers and school district employees, which means more money being spent in the community.
“Then there are transaction fees, attorney’s fees, transfer fees, survey crews, title company fees — it has such a ripple effect on the economy,” Lester said. “Those sales impact the secondary and tertiary markets and help stimulate the economy.”
Said Rowley: “It allows the churn in the business: the title service, the environmental audits, the deed-recording taxes, the mortgage-recording taxes.”
Not everyone sees preservation of the 1031 exchange as necessary. Critics ask why should the real estate industry get special treatment? Much of that is a misunderstanding of the tax code, Lester said.
“Oftentimes the public opinion looks at it like the real estate world is getting away with something; you’re not,” he said. “You have to pay it eventually, it’s just deferred.”
Said Danielle Ridgely, associate in the business finance department at Woods Oviatt Gilman: “The gain does not go up in smoke. The code does not say ‘If you do a Section 1031, you never pay tax.’ ”
Rowley would argue that in some cases, there is no guarantee of what the deferral will mean.
“What are you deferring into?” Rowley said. “What are the tax rates going to be next year or in five years? The tax rate might be higher than you expected.”
What commercial real estate folks do forecast is a significant hit to the industry if the 1031 exchange disappears. Lester estimates that perhaps as much as 20 percent of deals are completed because the 1031 exchange exists.
“You have a multibillion-dollar 1031 exchange market in the country,” Lester said. “The 1031 exchange provides an opportunity to defer the gain and helps facilitate transactions. It makes tough deals easier to get done.”
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