2014 and 2015 have been banner years for real estate transactions under the guise of 1031 tax deferred exchanges. With this strong performance the Washington politicians and the current administration alike have once again set their eyes on proposals to eliminate or put limits on exchanges. Politicians and governments in general see any form of profits and business growth with yearning eyes and desire as being yet another source to tap into to help satisfy their insatiable thirst for bureaucratic expansion…the 1031 market would indeed be a juicy target.
The 1031 exchange is not a new tax strategy but has been around since 1921 when US law first set forth that exchanging one property held for business or investment purposes for a similar property should not be taxed. The past two federal budgets proposed by the current administration would have taxed such exchanges.
So what’s at stake here and why is the 1031 program so important for real estate and the economy?
Without the 1031 tax deferral program investors are discouraged from expanding their holdings and thus impacting jobs as many investors would opt to hold onto their old properties indefinitely. If investors could no longer reinvest their monies into new properties growth would be impacted and reinvestment to improve otherwise depreciating properties would fall, discouraging both reinvestment and entrepreneurship. Investors would likewise have to borrow more money themselves to make improvements, thus adding to the debt burden of the country. The repeal of the program would also cause a severe freeze in the liquidity in the industry.
A recent study done by Dr. David Ling, finance professor at the University of Florida College of Business examined 1.6 million transactions over the past 18 years and concluded a repeal in the 1031 program would result in severe economic impact to the overall economy. For commercial properties, the effective tax rate increase would mean that investors would have to pay 7.7% less for properties to generate the same return they would have had otherwise, thus driving down values. For residential rental properties he concluded that to provide the same level of return investors would pay 10.6% less, or rental income would have to increase by 11.8%.
The dichotomy here is that a repeal of the 1031 tax deferral program would actually reduce net tax revenues to the Federal government rather than increase it like they would have hoped. Less job creation, lower property values, increase debt, and fewer transactions altogether at lower prices….not a good recipe for keeping the US economy on the right track.