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1031 and Other Proposals—The Reasoning and The Ramifications Across Commercial Real Estate

In a turbulent election year, a lot of our political discourse deals with hypothetical ‘what if’ questions. But the recently proposed tax changes from the Biden administration and their potential effects on the US commercial real estate sector has us asking a slightly more urgent version of that question—‘if yes, what then?’.

When President Joe Biden introduced the American Families Plan, it included a host of other programs, including universal preschool, free community college, and national paid parental leave. One of the questions surrounding this proposed Plan includes a natural question about the requisite tax changes that have been proposed to pay for the Plan, which currently has a price tag of roughly $1.8 trillion. While none of the proposed changes have been approved or instated, the ‘if yes, what then?’ question is particularly interesting for the commercial real estate sector as a whole.

An Overview of Section 1031

The proposed elimination of 1031 exchanges is one of the changes that’s seen the most feedback and conversation sector-wide. Section 1031 of the Internal Revenue Code has a long history in the real estate industry. It was first introduced as part of the Revenue Act of 1921, allowing a tax-free swap of properties that are held for business or investment purposes. There are a lot of regulations regarding which properties qualify in what time frame and with what rules, but 1031 exchanges are still used frequently by investors to change the form of their investment while deferring capital gain taxes. This strategy is so common among investors in the real estate world that the title ‘1031’ is very widely understood by even novice real estate investors.

Biden’s new economic plan, if executed in the way the administration has proposed, would include the abolishment of a real estate investor’s ability to defer that capital gain tax. This comes as part of an effort to raise taxes on wealthier individuals to bring the plan to fruition. But since like-kind exchanges are such a popular investment strategy, the changes would hit all types of real estate investors, from large commercial real estate investors down to smaller-scale, highly involved landlords.

Unintended Consequences

A 2015 study by David Ling and Milena Petrova studied some of the other (unintended) negative consequences that passing a bill like this could have on the market. Their study found that not only do like-kind exchanges encourage investment, they also generate a large amount of federal tax revenue, drive significant job creation, and ultimately result in less debt. Their study also suggested that the figures offered by the government on the cost of like-kind exchanges are exaggerated, and so the benefits of implementing a change to the 1031 rule could be overstated.

Maybe the most important perception to break down is the idea that like-kind exchanges result in the permanent deferral or avoidance of tax. Ling and Petrova’s study found that to be categorically false—roughly 88% of exchanged real estate properties are eventually sold in a taxable way, resulting in a great amount of tax paid than there would have been had the like-kind exchange not taken place. In tax-heavy states like California, Colorado and Arizona, like-kind exchanges make up anywhere from 10-18% of real estate transaction, and Section 1031 rules are actually more likely to include property improvements, with investors spending roughly 27 cents to 40 cents more per square feet on exchanged properties than they would a purchase made through an ordinary sale.

In their May blog post, UBS touches on this point briefly, mentioning that the 1031 exchange has been part of the commercial industry landscape for a long time, and that its elimination could lead to a significant decrease in transaction volumes and price discovery, a negative outcome for the commercial real estate industry.

The Biden administration also proposed an increase to the top personal bracket, up 2.6%, and an increase to the dividends tax rate for households making more than seven figures. They mention changes to the tax rate on carried interest, inherited assets, and the amount of tax on earnings that goes toward Medicare for households above an income threshold. It’s too early to tell which of these changes will be accepted by Congress, and in what form. But considering the history behind 1031 exchanges, it’s clear that even the thought of change is enough to turn heads in the commercial real estate sector, as different variations of the ‘if yes, what then?’ question steals the headlines.