Commercial Investors Worry About Possible 1031 Exchange Rules

WASHINGTON – One proposal in President Joe Biden’s $1.8 trillion American Families Plan has been drawing close attention from concerned commercial real estate investors. It would place a $500,000 limit on 1031 exchanges, which allow investors to defer paying tax on real estate gains if they reinvest the proceeds to buy other property within six months of the sale.

The bill would limit gains to $500,000 for each taxpayer ($1 million for married taxpayers filing a joint return) each year for real property exchanges that are like-kind. Any gains from like-kind exchanges in excess of these limits would be recognized by the taxpayer in the year of the exchange. The tax break has been in the U.S. tax code since 1921.

Putting a limit on 1031 exchanges “would absolutely slow down the movement of capital in the industry,” said Keith Sturm, a principal with Minneapolis-based Upland Real Estate Group.

A proposed increase in the capital gains tax from 20% to 39.6% would also reduce returns for real estate investors.

“Most commercial real estate transactions are pretty high-dollar amounts, $1.5 million-plus. People don’t like paying 40 to 50% in taxes on the value of properties. So instead of selling and losing half of their value they just might decide to hold onto the property,” Sturm said.

According to a study supported by accounting firm Ernst & Young, eliminating 1031 exchanges would negatively impact the economy by up to $13.1 billion annually. One analysis (backed by research from Ernst & Young) found that a repeal of 1031 exchanges would likely result in less federal tax revenue.

In a statement, the National Association of Realtors pointed out that 1031 exchanges are used primarily by retirees, investors and landlords, not by the super-rich.

To qualify for tax-free deferral of a gain, the law also requires that before an investor closes on the sale of property to be used for a 1031 exchange, they enter into a contract with a qualified intermediary who will receive (temporarily) the sale proceeds similar to escrow. The intermediary holds the funds until the new property is purchased, said Brad Williams, a real estate attorney and partner with the Dorsey & Whitney law firm in Minneapolis.

Williams said so-called “reverse exchanges” in which a replacement property is identified and purchased first, have become more common than in the past. That’s driven by the intense competition among buyers for suitable properties, in a “hot” market.

In some cases, the tax deferral enables 1031 property buyers to pay higher prices for more desirable properties, or put money into necessary improvements, Williams pointed out.

1031 exchanges are not always relatively simple deals of exchanging one property for another, Williams said. With new developments funded by multiple sources of 1031 capital, “some of those deals can get pretty exotic.”

Bill Katter, president and chief investment officer of United Properties Development, pointed out that tax deferrals for like-kind exchanges are not unique to real estate, but are also available in every other asset class, including stocks. Historically the exchanges have been heavily favored by investors to defer gains. Exchanges “have fueled liquidity in our business, particularly for long-term, net-lease property; for example, a Starbucks location with a 10-year lease,” Katter said.

The 1031 exchange has often been used by farmers who sell their land for single-family home development. The 1031s are usually focused on predictable income, as opposed to high-risk acquisitions, such as an office building which relies on a few tenants to generate income. “Single-tenant retail and multifamily housing properties are good candidates for 1031 buyers,” Katter said.

United Properties has developed a number of 7-Eleven retail outlets in Colorado, “and most of our buyers have been selling raw property or farmland.”

Farmers are allowed a “green acre” tax deferment when they sell land if it will continue to be used for agriculture. Otherwise, 1031 exchanges are the only way to avoid a big tax bill on such transactions, Katter said.

How likely is the prospect that 1031 exchange gains will be capped?

“There are differing opinions on that in the industry,” Katter said. “The consensus is that it is not likely to go away.” But the odds are not zero. He said real estate investors considering a 1031 exchange should stay well-informed on the applicable tax law discussions taking place in Washington.

Mox Gunderson, senior director of capital markets with the Minneapolis office of Jones Lang Lasalle, said he has recently observed “an increase in velocity” in 1031 transactions, possibly attributable to the possible change in the law. About half of the transactions his office handles as an intermediary broker are 1031 exchanges, many in the currently robust market for industrial properties. He also believes it is unlikely the proposed cap will become law, considering the positive impact the availability of 1031’s has on the economy.

“Any potential changes in the 1031 rules are certainly a concern to sellers,” said Sturm. “If the 1031 went away it would totally change the dynamics of real estate investment.”

One transaction typically triggers multiple transactions, he noted. “It might start with someone selling an apartment building in California. That person might do an exchange and buy a Walgreens in Minneapolis. The guy who sold that Walgreens might buy a Chick-fil-A [restaurant] in Tennessee. Eventually, somebody pays the taxes,” including state and local transfer taxes generated from each of the transactions.

Service providers involved in these transactions might include title companies, 1031 exchange companies, environmental companies, real estate brokers, lenders and attorneys. All of these service providers are paying income tax for the revenue generated, Sturm pointed out.

The 1031 exchanges also have the effect of promoting the “highest and best use” of ag property, for example a vacant property that is transformed into multifamily housing.

The time constraints placed on 1031 exchanges have a positive impact by inducing sellers to make decisions and complete new acquisitions within the time limit. Without exchanges, “I would expect velocity to slow tremendously.”

Also, without an exchange, a certain property may not be salable, where taxes would be higher than proceeds would be from a sale, Sturm said. “That happens quite a bit with farmland.”

Sturm believes the proposed cap originated with people who don’t understand how the 1031 process works. “Once people understand the process and what it is doing [for the economy], very few people would want to have it eliminated.”

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