The Juice Isn’t Worth the Squeeze

Mr. President, there are many reasons why we shouldn’t cap the 1031 like-kind exchange.

Key takeaways:

Research shows like-kind exchange transactions have a multiplier effect in a community when it comes to creating and maintaining jobs.
Exchanges serve as a crucial component to attract development dollars to underserved communities and an important tool for land conservation organizations.
For farmers, ranchers, and other land owners, like-kind exchanges are analogous to a retirement plan, enabling them to defer taxes on their assets until they retire.

When President Joe Biden released his $1.8 trillion American Families Plan in April, one of the ways he proposed to pay for the increased federal spending was to limit the Internal Revenue Code Section 1031 like-kind exchange deferral amount to $500,000.

According to the president’s own numbers, the proposed cap would generate $2 billion a year for the U.S. Treasury Department. The problem is that the change would cost the government more than it would save. A recent study by Ernst and Young estimates that the current like-kind exchange provision generates almost $5 billion per year in direct and indirect federal taxes, along with billions of dollars in state and local taxes.

And it’s not just the federal government’s bottom line that would be hurt by a cap on the 1031 tax deferral. When you consider all the ways 1031s are used to benefit communities and individuals, it’s clear that the juice isn’t worth the squeeze!

Investment in Underserved Communities

For 100 years, the like-kind exchange has allowed real estate owners to exchange their property for other income-producing properties and defer the tax on any unrealized gain. When the owner eventually liquidates the investment, the government collects taxes on the gain. Often, the new property grows in value beyond the original investment, thus yielding increased tax revenue for the government. While there are rules about the time frame in which an exchange must be completed, there’s no cap on the amount a property owner can defer using this tax strategy.

By enabling property owners to channel gains into new real estate investment, like-kind exchanges serve as a crucial component to attract development dollars to underserved communities.

“As the Black community explores avenues for growth of their financial opportunities … the 1031 like-kind exchange is more important now than ever,” says Norman Alexander, president of the Ridgecrest Area Association of REALTORS® in Ridgecrest, Calif., and a member of the California Association of Black Real Estate Professionals.

The additional capital saved by not having to pay the tax immediately could invigorate an abandoned shopping area or an underused warehouse, allowing owners to transform outdated properties into more productive uses, such as affordable workforce housing or a job-generating e-commerce hub. A 2020 study by David Ling of the University of Florida and Milena Petrova of Syracuse University confirmed that the like-kind exchange garnered appreciably greater capital investment in properties compared with those purchased without an exchange.

“Every time we sell an apartment complex, we use the 1031; if it were not available, we would not be able to complete that transaction,” says Bill Brown, 2017 president of the National Association of REALTORS® and owner of Springhill Real Estate Partners. Brown’s company, based in the San Francisco Bay area, invests in multifamily properties in cities such as Boise, Idaho; Portland, Ore.; and Phoenix. “My company spends anywhere from $7,000 to $10,000 per unit on remodeling,” Brown says. “This helps provide jobs for laborers, as well as materials such as carpeting, cabinets, and many other goods.” Such upgrades not only provide jobs but also improve the quality of life for those who rent and live in the apartments.

David Doig, president and CEO of Chicago Neighborhood Initiatives, brought a national grocery store chain, Kroger’s, into a food desert in the Bronzeville neighborhood on the city’s South Side. The site, formerly the demolished Ida B. Wells public housing complex, had remained a vacant lot for more than 15 years. In its place, David’s company developed a Mariano’s supermarket, and then a New York investment group purchased the new development through a 1031 like-kind exchange. This outside capital infused jobs, housing, and commerce into the community.

“We need to keep the 1031 like-kind exchange as is because it is another tool to encourage private capital to flow into commercial real estate projects that will help revitalize our underserved communities,” says Leon Walker, president and CEO of DL3 Realty and the developer who brought Whole Foods, Starbucks, and Chipotle into Chicago’s South Side Englewood community.

Investment in Job Creation, Pension Income

Jobs. Jobs. Jobs. Everyone along the political spectrum agrees that a robust job market is important for creating pathways to economic growth. Research shows like-kind exchanges have a multiplier effect in a community when it comes to creating and maintaining jobs. The Ernst and Young study concludes that if Section 1031 were limited or eliminated, real estate transactions would decrease, the cost of capital would increase, and the gross domestic product would contract. The study found that, under the current law, 1031 exchanges generate $4.4 billion in additional investment and support 568,000 jobs each year. This equates to labor income of $27.5 billion in 2021. A majority of these jobs come from the capital improvements that are made to properties after a like-kind exchange, which create jobs for electricians, carpenters, plumbers, contractors, masons and building material suppliers.

“Our local IBEW is very involved with economic development,” says Frank Furco, business manager of the Warrensville, Ill.–based International Brotherhood of Electrical Workers Local 701. “The 1031 like-kind exchange is a great tool to create jobs for our members.”

And jobs aren’t the only reason unions support 1031 like-kind exchanges. Section 1031 transactions are important to real estate investment trusts and, therefore, the pensions and 401(k) plans that invest in REITs. Specifically, Section 1031 enables a REIT to effectively manage its real estate portfolio, exchanging properties to manage risk and maximize return. This benefits both working and retired Americans who own REIT stocks in their retirement savings funds—especially trade unions, like IBEW 701, that fund their own pensions. Members of unions often work and live in the very same communities that benefit from the economic expansion provided by the 1031 like-kind exchange.

Investment in Land Conservation

While a like-kind exchange can be a great way to generate capital for development, it can also serve a very different purpose: the preservation of open space.

A major initiative for the land conservation community is to protect 30% of the nation’s lands, rivers, lakes, and wetlands by 2030. Known as The 30 by 30 Initiative in the conservation community, the initiative aims to preserve the integrity of our ecosystems.

Land conservation organizations rely on like-kind exchanges to preserve open spaces for public use or environmental protection. Land conservation transactions often involve the exchange of environmentally sensitive areas for less sensitive, privately held properties or the offer of conservation easements. A landowner electing to be paid for a permanent conservation easement can use those proceeds to acquire replacement property through a 1031 like-kind exchange.

These organizations have used the 1031 like-kind exchange to preserve and protect a wide range of environmentally sensitive lands, including the Rookery Bay National Estuarine Research Reserve in Florida, the Mississippi River Watershed, the Grassland Reserve Program in Idaho, and the South Boulder Creek Watershed in Colorado.

A Strategy for Farmers and Ranchers

The family farm has played an important role in U.S. history and remains a cornerstone of American culture.

Farmers and ranchers use 1031 like-kind exchanges for a variety of reasons, including:

Combining acreage for better production
Acquiring higher-grade lands
Improving the quality of their operations
Reconfiguring their assets so that young or beginning farmers can join in the business

In addition, when retiring farmers have no one to take over their family farm, they can exchange their farm or ranch for other types of real estate that generate ongoing retirement income. In the process, they may be providing land needed for home development or other uses.

The 401(k) of Real Estate

There’s a misconception that 1031 like-kind exchanges are a tool for the rich to dodge real estate taxes. This notion twists and contorts the true, progressive goal of the tax code: to help Americans build personal savings and ensure income for the future. In many ways, 1031 like-kind-exchanges are analogous to 401(k)s or traditional individual retirement accounts.

As with tax-deferred retirement accounts, like-kind exchanges allow real estate owners to reinvest their profits from the sale of income-producing properties into other similar income-producing properties and defer, not dodge, the taxes. When the owner eventually liquidates the investment, the government collects its rightfully due taxes.

In one real-life example, a widow in Southern California was forced to sell her husband’s auto service business when he passed away. The real estate portion of the business formed a large percentage of the sale. By using a like-kind exchange to defer the capital gains, she was able to acquire a replacement property that generates monthly cash flow from rental income. The subsequent property effectively has become her IRA account, providing her with a nest egg for her retirement income.

Like retirement accounts, the like-kind exchange has helped Main Street business owners establish and increase their wealth, and it has also provided economic growth and job creation for our economy over the last 100 years.

Very little privately owned real estate is held in IRAs or 401(k) plans. Of the roughly $30 trillion in IRA or 401(k) accounts, less than 2 percent is invested in real estate, and most of that is concentrated in publicly traded REITs.

Real estate investing serves a wide range of ends—bringing capital into underserved communities, conserving open land, providing income for retirees, and much more. And one of the most important financial tools for investors is the 1031 like-kind exchange. When people argue for capping the 1031 tax deferral, remember: The juice isn’t worth the squeeze.

Source: “The Juice Isn’t Worth the Squeeze“