Since 1921, investors in commercial properties have been allowed to defer paying capital gains when selling a property as long as they do a like-kind exchange.
When IRC Code 1031 came under fire in 2014 as part of a comprehensive tax reform package considered by Congress, the question arose, just how beneficial is the rule?
The long-term and short-term impacts of changes to the provision are examined in The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate, a recent study by professors David C. Ling of University of Florida and Milena Petrova of Syracuse University.
Section 1031 exchanges are a tax-deferral mechanism, not a tax-free transaction, and successful implementation is subject to certain procedures and parameters.
Real estate and other types of property – such as vehicles or equipment – qualify as long as they are used in a trade or business. The like-kind portion of the rule is applied to the property exchanged, for example real estate for real estate. The purpose and function of the real property don’t need to be the same as long as both are commercial properties.
Taking advantage of Section 1031 requires meeting two deadlines. Within 45 days after the sale, a suitable property must be identified. Within 180 days, the second closing must occur.
Section 1031 can be used multiple times if investors purchase and sell a series of properties. While the second property is identified and purchased, the cash from the first sale must be held by a designated intermediary. Two caveats: Any cash or other assets received outside what is transferred to the new property are taxable as is any mortgage or debt forgiveness.
Those opposing the rule believe that the deferred capital gains tax has a significant impact on government revenues. Ling and Petrova assert the opposite. Their study reviewed 1.6 million transactions over an 18-year period to calculate the costs and benefits of Section 1031.
Multi-family homes were a leading category in like-kind exchanges, they found. Key findings include the following:
- Like-kind exchanges result in greater investments, with replacement properties valued higher than the original property.
- One-third of exchanges result in some tax being paid the year of sale.
- Over the long run, capital gains tax income is boosted (by 19 percent) as property investments rise.
- Like-kind exchanges often reduce property-owner debt.
- Construction jobs are created through like-kind exchanges as property upgrades and renovations are performed.
The study also reviewed what would happen if Section 1031 were repealed. It was estimated that the effective tax rate on commercial property investors would rise from 23 percent to 30 percent.
In turn, this would create downward pressure on property values to preserve equity investment returns. Rents would also increase as property owners seek to make the property’s cash flow and provide return on investment. In addition, the like-kind provision appears to spur turnover of properties. Holding periods for properties involved under Section 1031 were significantly shorter.
This analytical look at Section 1031 provides informed, number-based data regarding the benefits of the rule to the commercial real estate and construction markets. Property owners should consider using like-kind exchanges to improve their financial positions as well as the value of their real estate portfolio.