With the talk of tax reform that would repeal or limit 1031 Exchanges, the global effect of changing like-kind deals is in the spotlight.
Section 1031 Exchanges, or like-kind exchanges, are used in commercial real estate to allow investors to reinvest their profits into a new property through an exchange of a similarly valued property and defer the taxes from the sale.
The proposed limitation in President Barack Obama’s 2016 budget would cap a deferral of capital gain at $1M.
“Historically, Section 1031 deferral has been justified on the basis that valuing exchanged property is difficult,” according to the U.S. Treasury Department’s general explanations of the administration’s 2016 budget. “However, for the exchange of one property for another of equal value to occur, taxpayers must be able to value the properties. In addition, many, if not most, exchanges affected by this proposal are facilitated by qualified intermediaries who help satisfy the exchange requirement by selling the exchanged property and acquiring the replacement property. These complex three-party exchanges were not contemplated when the provision was enacted. They highlight the fact that valuation of exchanged property is not the hurdle it was when the provision was originally enacted. Further, the ability to exchange unimproved real estate for improved real estate encourages ‘permanent deferral’ by allowing taxpayers to continue the cycle of tax deferred exchanges.”
“Every commercial property potentially could be a 1031 Exchange,” says Dave Tornell, vice president for Investment Property Exchange Services, Inc. (IPX 1031) in Arizona and New Mexico.
Colliers International Senior Vice President Rob Martensen closed three 1031 Exchanges last December, only one of which he believes would have been able to happen without the option of an exchange.
Tornell and Phoenix Commercial Advisors Senior Managing Director Chad Tiedeman project that about 40 percent of transaction volume is influenced by 1031 Exchanges. At PCA alone, the team’s three investment brokers sold 23 retail investment properties totaling more than $100M. Fifteen of those sales, a majority, had buyers who used 1031 Exchanges. Martensen and Tiedeman note that a significant percentage of buyers are Californians looking for higher cap rates.
A repeal of the tax section would raise tax burdens on those involved in transactions, which can lead to longer holding periods, reliance on debt financing and less productive deployment of capital in the economy, according to an Ernst & Young study released in March and commissioned by the Section 1031 Like-Kind Exchange Coalition.
“It’s important in general. It gives people more reason to trade a property,” says Martensen. “I don’t need to do the research to know that if 1031 were not allowed anymore, it would have a major impact on the economy.”
The largest 1031 Exchange last year occurred in New York City, when the Waldorf Astoria Hotel went for $1B. In Arizona, the largest exchange in 2014 was a $50M land deal.
“As for 1031 Exchanges in Arizona, we are close to 2004 levels,” says Tornell. “The market has recovered significantly from the bottom, which was 2009. During 2009, 2010 and most of 2011, 1031 transactions were almost nonexistent. Then, as the markets started to recover and every year since, we have seen an increase in 1031 activity. One of the larger qualified intermediaries had a 32 percent increase in transactions from 2013 to 2014 and the first quarter of 2015 is up over last year.”
Furthermore, Tiedeman, who does not support the proposed changes, adds that one-third of jobs in Arizona are tied to real estate in some capacity.
“If the law did get repealed, it would be devastating,” he says.