The history of 1031 Exchanges in commercial real estate is almost as long and complicated as the creation and evolution of the first modern U.S. income tax code. In the early 20th century, the U.S. government needed revenue desperately after entering World War I, which was one major factor for the creation of the Revenue Act of 1918. The 1918 act that created the first modern income tax code didn’t include a provision for like-kind exchanges. That meant that anyone selling a property (real or otherwise) to buy another identical one would have to pay tax on the gain. The thinking was that this person’s position was left relatively unchanged and might not have the revenue to pay for their tax bill. The Revenue Act of 1921 changed this by creating the 1031 exchange structure, designed to provide relief to taxpayers via a deferral strategy that encouraged real estate investors and taxpayers to continuously reinvest their money.
One hundred years later, 1031 exchanges are very common in real estate investing and have gone through a multitude of changes, including threats of restriction and elimination from politicians who consider it a tax loophole or tax-avoidance strategy. In the past couple of years, commercial real estate investors have been biting their nails about the fate of 1031s, as the Biden campaign and then administration vowed to restrict them. It appears like-kind exchanges may have dodged a bullet, but those in the commercial property industry should still keep a close eye on what the Biden administration and Congress decide to do. As many real estate investors have argued, restrictions on 1031s would likely affect the flow of capital in real estate deals and impede investors from building wealth. As many tax advocates have argued, this provides a way for the wealthy to avoid paying their fair share in taxes. Whether or not Congress decides to place a cap on them remains to be seen, and it’ll be closely watched by millions of investors across the country.
Who’s afraid of 1031 limitations?
A 1031 exchange is a method of exchanging real estate so that all or most capital gains taxes are deferred to the future, according to a definition from Horvath and Trembly, an investment real estate brokerage firm. The exchanges allow real estate owners to swap out current investments for new ones without recognizing capital gains and allowing investments to continue to grow tax-deferred. Commercial property investors can realize significant benefits from 1031 exchanges, including reinvesting into a potentially higher-income producing property and replacing a property with greater management responsibilities into one that has lower or zero maintenance liability, such as a single-tenant, net-leased property.
Only investment and business properties apply for 1031 exchanges, other types of real estate such as primary residences and vacation homes do not. When like-kind exchanges were initially conceived, the tax code required the property to be exchanged for the exact same type of property. But that changed in the 1990 re-write of 1031s, and now it’s legal and common to exchange one type of investment or business property for another. For example, an apartment building could be exchanged for various types of investment real estate, including vacant land or a shopping center. The vast majority of exchanges done are called ‘deferred exchanges,’ which means the replacement property being swapped must be identified within 45 days and purchased within 180 days or up to the date when that year’s income tax is due. Deferred exchanges give investors more time and flexibility to structure a sale of a relinquished property and a purchase of the replacement property.
As commercial real estate investors feared, the Biden administration proposed tax reforms in May 2021 that would place a $500,000 limit on 1031 exchanges for each taxpayer (and $1 million for married taxpayers filing a joint return) each year for real property exchanges that are like-kind. The proposal said any gains above those limits would be recognized by the taxpayer during the year of the exchanges. A proposed increase in the capital gains tax from 20 percent to 39.6 percent would also take a chunk out of returns for CRE investors. Keith Strum, a principal with Upland Real Estate Group, told MinnesotaLawyer a limit on 1031 exchanges would “absolutely slow down the movement of capital in the industry.” Strum noted that most CRE transactions are high-dollar amounts, usually more than at least $1.5 million. With the proposed tax reforms, he said CRE investors would be more likely to hold onto their properties instead of paying up to 50 percent tax and losing half of their values.
The Biden administration’s reasoning for the restrictions on 1031 exchanges and other tax reforms on investment assets is that it would increase government revenue by $19.6 billion over 10 years and help fund the administration’s objectives. But even if this estimate is accurate, that $19.6 billion in extra revenue would fund only 1.6 percent of the $1.6 trillion infrastructure plan, according to KJ&K, an Ohio-based law firm that serves local and national businesses. Critics of restrictions on 1031s agree there’s an ongoing need to fund growing government expenses and the sweeping new legislative initiatives like COVID-19-related stimulus packages. But they say that going after 1031 exchanges is misguided and could have far-reaching unintended consequences.
An analysis by accounting firm Ernst & Young (EY) said that a repeal of 1031 exchanges would lead to less federal tax revenue, discourage real estate investment, and negatively impact the economy by up to $13.1 billion annually. EY’s research indicated that 1031s encourage businesses of all sizes to relocate into properties that better suit their current and future needs, leading to the highest and best use of property and supporting economic growth. The National Association of Realtors also noted in a statement that 1031 exchanges are essential to keeping the commercial real estate market progressing, and they’re used primarily by retirees, investors, and landlords, not the super-wealthy.
Stay tuned in to D.C.
While some have labeled 1031s as a loophole, others beg to differ. “Like-kind exchanges facilitate the overall flow of the real estate investment industry, with about 15 percent of all real estate transactions in the U.S. being like-kind transactions,” argued John Harrison, DBA, of the Alternative & Direct Investment Securities Association in a letter to the Wall Street Journal. Harrison wrote that a majority of exchanged properties are sold after one round, leading to higher-paid tax amounts over time that would have otherwise been due. “This reinvestment accelerates the velocity of money and prevents extended holding periods that lead to stagnation,” he wrote.
The Biden administration’s tax reform proposal had some real estate investors worried, and there’s anecdotal evidence it fueled increased like-kind exchanges in the past couple of years. But many other commercial real estate investors have said they doubt 1031s will be repealed or restricted simply due to the immense positive impact they have on the economy. Strum, the principal for Upland Real Estate Group, also told MinnesotaLawyer the proposed 1031 restrictions likely originated with someone who didn’t understand how they worked. Strum said that once people understand the benefits of like-kind exchanges for the economy, “very few people would want to have it eliminated.” For now, it appears 1031s may be safe, due in part probably to the pressure placed on Congress and the Biden administration by a coalition of trade groups like the Federal Exchange Accommodators and 1031 Crowdfunding. The 1031 Crowdfunding group launched a campaign in strong opposition to the tax reforms and sent more than 700 letters to Congress.
In September, the House Ways and Means Committee provided draft legislation language for Biden’s American Families Plan, which was supposed to include the proposed cap on 1031 exchanges. However, the draft legislation made no mentions of restrictions on 1031s, which groups like 1031 Crowdfunding have claimed as a victory. “So, while there’s a chance this could change, it is improbable that the proposed changes be reintroduced in future revisions,” 1031 Crowdfunding wrote in September on its website. Limits on like-kind exchanges appear to be safe for now, as Congress is focused on other changes to the real estate industry, such as Low-Income Housing Tax Credits and zoning reform.
1031 exchanges have been around since 1921, and they have a long and complicated history in commercial real estate. Despite challenges in the past and being labeled a tax loophole, like-kind exchanges have survived and become a common and very beneficial part of the tax code for real estate investors. The Biden administration is not the first to target 1031s, and they likely won’t be the last. While restrictions or elimination of 1031s appear unlikely for now, those in the property industry should keep a close eye on future developments to ensure it stays that way. As numerous research has shown, like-kind exchanges can increase your buying power, allow you to reinvest in higher-income properties, and swap properties with significant management for ones with lower maintenance liability. This is all done by deferring capital gain taxes to the future. On an industry-wide scale, 1031s accelerate the flow of money in real estate deals and often trigger multiple transactions that help fuel business growth. Stay tuned to the fate of like-kind exchanges in the nation’s capital, because it’s one part of the U.S. tax code that most real estate investors don’t want to see messed with.