How would the proposed repeal of the 1031 Exchange provision affect CRE?

The 1031 tax-deferred exchange could soon become a thing of the past. Congress is considering its repeal, arguing that it’s necessary in order to fund the lowering of corporate income tax rates.

This was suggested in the Tax Reform Act of 2014, a 1,000+-page document presented by Michigan Representative David Camp, who recently retired. The wheels of Congress grind exceedingly slow, as we know, and the repeal may not happen for years, but it’s a good idea to understand the implications of a repeal. 1031 exchanges have been targeted for elimination for years, with repeal proposed in the Senate as far back as November 2013.

On the books since 1921, the provision has helped commercial real estate investors diversify their holdings and increase their portfolio value. It allows for deferment of capital gains tax on sale of a commercial property when the proceeds are put into purchase of another property which is held “either for productive use in a trade or business or for investment".  Although these are referred to as “like-kind” properties, the rules allow for the exchange of a surprising variety of investments – an apartment building for a strip mall, for example. The exchange can also be delayed for up to 6 months while a suitable property is secured for purchase.

The 1031 exchange allows the use of 100% of equity towards the purchase of a new property –in effect “exchanging” the properties without a tax on gains in the sale. It offers preservation of equity, diversification and leverage towards purchase of higher-value properties.

The Obama administration has also weighed in on 1031 exchanges. The proposed budget for 2016 calls for the provision to be retained, but would limit application of the provision to $1 million of tax deferral per taxpayer in any tax year.

What would this mean for the commercial real estate industry, and investors in particular?  It’s not a rosy picture, according to global business consultants EY LLP. In their recently published report, the research specialists concluded that repeal of 1031 exchanges would result in businesses holding property longer and relying more heavily on debt financing. They also predict less productive employment of capital in the economy if the tax deferred exchanges become unavailable. These conditions, the report continues, would lead to the following situations:

  • Our gross domestic product declining by $8.1 billion a year;
  • Investment in the economy declining by $7 billion a year; and
  • Annual income from labor declining by approximately $1.4 billion a year.

EY expects the following industries to be adversely affected by the repeal of IRC 1031: construction, real estate, transportation and civil engineering.

Whether the numbers in this report are spot-on remains to be seen, but it seems clear that the disappearance of 1031 exchanges would be something to mourn.  It would doubtless have a chilling effect on the ability of investors of any size to add value to their portfolio and diversify their holdings. How large an effect that will have on the growth of the CRE industry, one of the country’s largest financial markets, is a question that should be carefully contemplated by the powers that be.