Impact of Tax Code Reform on 1031 Exchanges

Today’s guest post is by Wayne D’Amico, CCIM, EVP of Corporate Development & Strategic Relations with Xceligent & Past President and Chairman of the CCIM Institute. Since 1987, D’Amico has been engaged in diversified services in nearly a billion dollars of commercial and investment real estate projects in the areas of strategic and valuation consulting, transactional brokerage and creative financing to a national clientele.

 

Stumping for the preservation of Internal Revenue Code Section 1031, Like Kind Exchange rule, appears to be another attempt by rich folk looking to keep their trough over flowing at the expense of the little guy.  Will the promised Trump tax reform preserve 1031 rules or gut them to the chagrin of investors?  It’s complicated, but let’s try to break it down.

 

The Tax Code provides that the seller of real estate does not pay tax on any increase in value (gain) at the time of sale – provided, the seller invests all the sale proceeds into another property.  The tax is not avoided, but deferred until the time that the owner sells and cashes out instead of buying another property.

 

Why was Section 1031 enacted nearly 100 years ago?  Unlike buying and selling stocks, real estate transaction volume, velocity and value stimulates economic activity.  How?  Every real estate deal results in more work for a variety of jobs including appraisers, brokers, consultants, engineers, lenders, inspectors, insurers and contractors.  Greater transaction volume requires more people to perform the ancillary jobs.  And as real estate values increase, more money goes to those jobs.   The rule incentivizes owners to reinvest sale proceeds into the next deal within 180 days generating tremendous velocity in the market.  If you believe in this argument that robust real estate transaction environments are drivers of the overall economy, then legislation that supports higher sales volume and velocity ensure favorable economic stimulus.  Need stats?  In 2014, the National Association of REALTORS study suggests that some 39% of transaction volume was associated with 1031 related deals.  Eliminating the 1031 code will reduce the overall capital available to buy future properties by 25 to 40 percent due to capital gains tax and reduce the velocity with the removal of the 180-day reinvestment requirement.  If the capital pool controlled by private investors is reduced, the economy will slow and shrink.

 

Can revision of this code be a good idea?  Sure.  The real estate investor is not a species that is inherently averse to taxation.  In fact, it’s really just math.  The decision to utilize the 1031 rule is not about an aversion to taxes empirically. It is the impact of the tax expense within a financial analysis of the return to the investor on and of her money invested in the real estate as it performs over time that matters.  The amount and timing of the tax are simply variables that plug into the proforma along with many more factors that result in an overall investment return.  If the right set of comprehensive tax reforms were put together as a part of the repeal of 1031 considering amongst other things depreciation, capital gain rates, real estate tax policies, overall economic conditions and interest rates to name a few, I can envision a world without 1031.  But, until I see such a proposal in detail, I’d rather keep the 1031 rule in place and let the private sector do the heavy lifting of stimulating the economy.