On Inauguration Day we continued our series on President Biden’s plans to raise taxes and change the tax code in ways that would have a direct negative impact on real estate markets across the country.
Today, we take another look at his campaign promise to eliminate 1031 tax-deferred exchanges, which have, for the past 100 years, been a key driver in market activity for commercial and multi-family residential real estate. While our own experience informs us of the many benefits of 1031 exchange rules, here we also rely on the definitive academic study on the topic, The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate, published in 2015 by Professors Richard Ling of the University of Florida and Milena Petrova of Syracuse University. The link to that study appears again at the end of this post for your own review.
The study makes clear with empirical evidence that 1031 exchange rules increase transaction volume, accelerate the flow of capital into the real estate asset class, increase additional capital investment, support job and wage growth, create additional wealth and improve the overall quality of life. To us, all good things that seem worth supporting going forward. The authors are also clear that elimination of 1031 exchange provisions will reduce transaction activity, increase hold periods, increase market risk, reduce property values, lessen demand, increase the use of leverage, decrease liquidity and, oddly enough, actually reduce tax revenues to state and local governments. All bad things that seem worth avoiding.
Yet, despite the obvious downside, the new administration will likely move forward with its proposals in order to make good on its campaign promises. Indeed, just the threat of eliminating like-kind exchanges will be enough to roil real estate markets in all 50 states, but especially in high-tax states like California, which accounts for over 39% of all exchanges nationwide. Combined with other proposed tax hikes, the negative impact would be accelerated. More on that in future posts.
So, the question is: if you had good cause to believe that exchanges would soon be disallowed, how would your investment strategy change and what action would you take? It is no secret that real estate lacks the liquidity of other asset classes like stocks and bonds. Those can be acquired and disposed of literally at the speed of light. Selling real estate takes several months even under the fast-paced market conditions that we experience today. Thus, it is important for you as an investor to be thinking ahead, and you may decide to take action before the fact, so as not to be caught trying to exit your investments along with everyone else. The industrial market is at an all-time high and many of you now have massive unrealized capital gains. The key word there is “unrealized”. Until you take action, your equity is at risk. For the past 10 years, things have been going your way, but a significant change to one of the fundamental drivers of real estate activity, the 1031 exchange, would be a major disruption.
Many of you have held on to your highly appreciated assets because you have a visceral aversion to giving more than a third of your gain on a sale to the Franchise Tax Board and the IRS. That’s certainly understandable, and your decision to hold has resulted in even larger unrealized gains. However, higher taxes and changes to the basic rules of real estate investing will, at minimum, slow further price increases and in the worst case, start a price correction that precipitates a reversal of the current market up-cycle as the prospect of change sinks in.
So, for those of you who have been contemplating a disposition via straight sale or via a 1031 exchange, you may be well-advised to take a closer look at those options before the consequences of changes to the tax law move beyond speculation. When a market peak is approaching, those who exit soonest fare best, as they market their assets before a significant reduction in demand begins. Right now, mortgage rates are at an all-time low point due to the Fed’s monetary policy. This gives owner/users the opportunity to fix occupancy costs at palatable levels despite the high price point. Currently, demand is running well ahead of the supply of industrial properties, for both investors and owner/users. As perceived market risk increases, demand will likely decrease just as supply begins to swell. That will create a gap that will impact pricing and increase marketing time for industrial assets.
Fortunately, the industrial sector is faring best of all commercial property types, in large part due to the explosive growth in e-commerce. During the pandemic, lease rates and sales prices have continued to increase and vacancy has fallen even further throughout Southern California. But, there’s a new sheriff in town and if his threat to eliminate 1031 exchanges becomes the law of the land, it could be a game changer.
Our position on the topic is clear, and we send you this message at the risk of sounding opportunistic. But, to us, the consequences of remaining silent are far greater. We urge anyone whose strategy included a sale in the next few years to adopt a new sense of urgency. If the exchange rules survive after a disposition, the chance of leaving additional equity on the table is certainly possible. But, as the old saying goes; no one ever lost money taking a profit. And, no one can purposefully and perfectly time their exit at the top of the market. The top is an unknown until the correction already has a head of steam. So, when timing your exit, it may be okay to be a few months early, but don’t be a single minute late.
- Microsoft Word – Ling Petrova Economic Impact of Repealing or Limiting Section 1031 6-22-15.docx (ipx1031.com)