Happy Halloween! The Progressive Real Estate Partners team always enjoys celebrating Halloween and this year It occurred to me that this might be the last year for another type of “10/31” – – aka the 1031 exchange which is currently on the menu of possible tax “loopholes” to be eliminated in an effort to make tax reform more revenue neutral. This is of considerable interest to the CRE industry and especially a firm like ours because we broker a significant number of 1031 investment sale transactions.
Simply stated a 1031 exchange allows investors to trade from owning one investment property where they have a capital gain to another investment property while deferring the payment of any capital gains tax. This tool is extremely valuable to the commercial real estate community because:
- It increases velocity in the market because investors are more willing to sell if they know they can defer capital gains taxes.
- Likewise It creates motivation for investors to buy since those in 1031 exchanges are much less likely to walk away from a deal if they know the only alternative is paying a significant amount of capital gains.
- Development and redevelopment of older properties and land is much more likely to occur with the ability to do a 1031 exchange. The current owner of a property may not have the skills or capital to redevelop a property but a 1031 exchange allows them to sell it to someone who does have the resources and then reinvest the proceeds into a newer asset. Without the exchange, the seller, especially with cash flowing properties may just do nothing which isn’t good for either the community or the economy.
- It allows individual investors to build wealth, without the friction of taxes, similar to how pension funds build wealth for their beneficiaries without having to pay taxes each time they transact.
At this point, I don’t think anyone knows what will happen relative to the repeal of the 1031 exchange, but clearly our industry needs to think about the ramifications of eliminating this important real estate tax deferment vehicle:
- There will likely be a window of time where transaction activity will be substantially reduced. I think it would be difficult for someone to justify selling a property in the 1st quarter of 2019 if they knew they could have sold and deferred the gain if they sold in the 4th quarter of 2018.
- Cap rates will likely move upwards as the pool of 1031 investors would be eliminated and therefore fresh capital would require higher initial returns than 1031 capital.
- Market velocity might be significantly different amongst low/no personal income tax states and high personal income tax states. For those in no/low personal income tax states, the repeal of the 1031 exchange rules could actually be good if accompanied by lower long term capital gains tax rates.
I think if you asked most investors whether they would prefer to pay a 15% tax (assuming it was lowered to this amount) and avoid a 1031 exchange with all of its rules and limitations OR do the exchange, most would probably opt to pay the tax. In high tax states, such as California, the additional barrier of a very high marginal income tax rate would likely cause many to hold their investments and avoid paying capital gains. This is even more true if the state tax is no longer deductible on your next year’s return.
What will happen with the 1031 exchange will likely be a hot topic of conversation with our clients over the next few months. We are already seeing clients considering selling assets that they do not foresee wanting to own for the long term so they can improve their position. We encourage all to pay close attention to this legislation and prepare accordingly.
In the meantime, I hope you and your family have a spooktacular Halloween!