There’s no denying that the upcoming presidential election and subsequent political changes will have a significant impact on the commercial real estate sector on a variety of different levels. Revisions to the existing tax code have been discussed by not only both presidential candidates, but by government officials for years. One of the most crucial changes for the commercial real estate industry is the potential effect on Section 1031 of the Internal Revenue Code (IRC), and what the lasting effects of these changes will mean for the entire commercial real estate industry and the economy in general.Section 1031, or more commonly referred to as a 1031 exchange, allows a property owner to sell a property without having to initially pay the taxes on any proceeds from that sale, as long as those proceeds are being reinvested into a similar property. However, the tax owed is deferred, not erased. The property owner must eventually pay those taxes when the property is sold.
So while 1031 exchanges have been very popular in the real estate market because of these tax deferrals, these types of transactions have been on the government’s chopping block for years. Or at the least, under the watchful eye of legislatures and considered for reform.
Both presidential candidates in the upcoming election are looking to reform the current tax code, yet neither has specifically commented on what their changes to the tax code would mean for Section 1031. There are beliefs that policymakers may repeal Section 1031 rules in order to raise revenues and offset the cost of other tax or spending proposals. Much of what will play out in regards to tax reform will boil down to what Congress allows and what their final decision will be. Ultimately, if changes are made, or Section 1031 is eliminated, it will have a devastating effect on the real estate market.
While 1031 exchanges may not create large sums of revenue for the government, they create a significant amount of economic activity, which may far outweigh any delayed tax revenue. According to a study done by David C. Ling and Milena Petrova titled “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate”:
“The elimination of real estate exchanges will likely lead to a decrease in prices in the short-run, followed by an increase in rents in the longer run. These negative effects will be more pronounced in high tax states. Elimination will also likely produce a decrease in real estate investment, increase in investment holding periods, and an increase in the use of leverage.”
The deals created by 1031 exchanges help fuel activity by keeping mortgage brokers, lenders, and banks busy with more deals and with origination fees. They keep appraisers, surveyors, phase one companies, inspection companies, and many others busy as well. These 1031 exchanges create traction for a variety of sectors, which also transcends into the tenant side.
Section 1031 exchanges allow investors to take on lower rates of return due to the fact that they are deferring their income tax. Let’s say you purchase a $2 million property through a 1031 exchange, with a tenant paying rent. That property will likely produce $100,000 in income, and the owner will be paying an annual income tax on that revenue, albeit a smaller amount than if they were paying on the initial profit if they didn’t use a 1031. This creates an annual taxable income stream versus a one-time capital gain taxable event from the sale of the property, which subsequently leads to continued money invested in our economy.
This in turn results in lower cap rates and lower rents for tenants, which ultimately leads to continued expansion for a number of retailers. The economy relies heavily on the expansion of these businesses, because continued expansion for retailers means an increase in construction and development, and an increase in job creation. All of these things help to fuel economic growth.
Changes in Section 1031 could easily result in higher rents because investors will be looking to meet their requirements in regards to their financial returns. Increased rents may result in retailers halting their expansion plans, which may have a significant ripple effect in not just retail, but office, medical, and more. Limited to no expansion by businesses means less construction, less job creation, and less economic growth.
With all of these factors in mind, it's important for different sectors of the real estate industry to understand the potential consequences of the elimination or reform of Section 1031. All of these sectors need to lobby together to ensure that Section 1031 remains intact, no matter the political outcome in November. It will take a vocal effort from the real estate industry as a whole to lobby against potential devastating changes for the commercial real estate business.