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Key Takeaways:
- Section 1031, in place since 1921, allows investors to defer paying capital gains taxes on the sale of investment property as long as the proceeds are invested into a similar (“like-kind”) property.
- Some policymakers and politicians view 1031 exchanges as a way for large investors to dodge taxes rather than defer them, but such claims fail to recognize that most participants are “mom and pop” investors and the transactions rarely lead to a permanent tax deferral.
- A high percentage of like-kind exchanges, as many as 88%, ultimately result in taxable sales. Removing 1031 exchanges entirely would reduce federal revenue and reduce other related economic activities.
Chances are that if 10 people walking down a city street were asked what a like-kind exchange is, nine of them would not know. But the truth is, those transactions are key to keeping communities vibrant.
Now this long-standing part of the tax code that greatly affects real estate, Section 1031, is at risk of being eliminated, an action that some researchers and advocates, including the National Association of REALTORS®, say would have adverse consequences for communities and their economic development. President Joe Biden has proposed doing away with Section 1031 like-kind exchanges to fund services for children and the elderly. Those are worthy services, to be sure, but eliminating like-kind exchanges of real property, which have been available to investors since 1921, won't accomplish the goal and will hurt the economy, according to new research.
Some policymakers and politicians view 1031 exchanges as a way for large investors to dodge taxes rather than defer them, but such claims fail to recognize that most participants are “mom and pop” investors, and the transactions rarely lead to a permanent tax deferral. Common criticisms of the provision have been countered by recent research by David C. Ling, professor of real estate at the University of Florida, and Milena Petrova, an associate professor in the finance department at Syracuse University. Ling and Petrova analyzed 816,000 commercial property transactions with a median sales price of $1.1 million (not adjusted for inflation) from 2010 to 2020 provided by the commercial data giant CoStar. Among their conclusions:
- The share of like-kind exchanges ranged from 10% to 20% of all commercial real estate transactions and involved mostly smaller deals.
- A high percentage of like-kind exchanges, as many as 88%, ultimately result in taxable sales. Removing 1031 exchanges entirely would reduce federal revenue and reduce other related economic activities.
- Eliminating real estate exchanges likely would reduce transactions in most commercial real estate markets and prices in some markets, at least in the short run.
- Elimination also would probably decrease capital investment on acquired properties and increase investment holding periods and the use of leverage to finance acquisitions.
The researchers found that 1031 exchanges significantly benefit not only commercial real estate owners and operators but also the economy in general. By deferring tax liabilities, exchanges can help preserve scarce investment capital that investors can use to acquire larger properties, upgrade portfolios, and make capital improvements. Those activities create jobs and expand state and local governments’ tax bases.
1031 exchanges also make commercial real estate, which is highly illiquid, more marketable. Increased liquidity is especially important to non-institutional investors in inexpensive properties, who account for most of the like-kind exchange market. And at a time when housing shortages persist in many markets, 1031s offer a viable option for investors interested in transforming underused or vacant commercial properties into multifamily and other residential developments.
The provision is of vital importance to many REALTORS®. Between 2016 and 2019, 68% of all commercial REALTORS® had at least one 1031 exchange transaction, according to NAR research. In addition, 12% of sales by commercial members were 1031s, as were 5% of sales of residential-focused members. More than 90% of NAR members expect property values would fall if 1031s were repealed.
As lawmakers debate the future of this critical yet often misunderstood tax provision, this up-close look at two transactions shows plainly how 1031 exchanges provide major economic benefits to communities as well the investors behind them.
From Eyesore to Welcome Sight
Craig Fernsler’s 95-year-old client knew she wanted to use a 1031 exchange to invest in a replacement property in 2014, but she did not know how to go about it. She had sold a farm in Williamsport, Pa., to a company that wanted to build a plant there. Of the $4 million purchase price, a little under $2 million had gone into a passive investment for her.
“My immediate goal was to find out what the client and her family’s risk tolerance was and what they were really looking for,” says Fernsler, ccim, senior director at KW Commercial in Blue Bell, Pa. “That gave me the direction I needed to search throughout the country for a replacement property.”
What Fernsler found in 2014, and the family chose, was an investment in a new corporate-guaranteed Wendy’s fast-food restaurant in Chicago.
“There were minimal risks,” Fernsler says. “If there’s only five years left on a lease, you’re going to have risk that the tenant will leave in five years. This was a brand-new 15-year lease with increases in rent that Wendy’s would pay my client. And Wendy’s would take care of snow removal, lawn care, and any repairs and maintenance. The [client’s] kids knew this Wendy’s would be staying in business.”
Although the investment risk was minimal, the property had a long and complicated past. “A dilapidated warehouse on the site had to be torn down,” Fernsler says. The building had been vacant for years and was occupied by a range of businesses dating back to 1924, including an auto repair shop, a tool and die manufacturer, and an acrylics factory.
Fast-food chains often attract developers and investors using 1031 like-kind exchanges, Fernsler says. The redevelopment process is complex, involving environmental cleanup and government approvals. It typically takes at least two years. Some chains use a list of approved developers who handle their projects. Investors who are older or have owned residential rental properties may opt for a 1031 exchange investment that generates passive income because they do not want the hassles that come with actively managing a property.
The developer for this project commissioned an environmental site assessment in 2012 that found a 550-gallon underground gasoline storage tank on the property and volatile organic compounds related to a storm sewer detention structure. When it was determined that the groundwater and soil were contaminated, the developer hired a company to oversee removal of the storage tank and collect samples for testing. Eventually, more than 4,200 tons of soil were removed and disposed of in accordance with environmental safety requirements.
Beyond remediation of the property, the cleanup hugely benefited the community, Fernsler says. “Think about the economic vitality added with cleaning up the area. Nobody was working in that run-down warehouse for years, but then employees were working at Wendy’s, in a clean environment.” The restaurant opened at a time when new condo and apartment complexes were emerging, drawing more people to the area, and creating more activity and traffic to nearby businesses.
In addition, the overall redevelopment has generated a lot of employment and significant tax revenue over the past seven years, Fernsler says.
“I worked with an attorney and a title company. The developer hired people to construct the building,” he adds. “Engineers were hired, as well as a surveyor, an attorney who took the project through the approval process with the municipality, and the municipality attorneys. Everybody that touched this was paying regular income taxes. And transfer tax was paid when the transaction happened. This kind of transaction creates a chain reaction, but if you take away 1031s, the chain breaks. If these transactions were done more, it would be a beautiful thing.”
Mall Rejuvenation
When a grocery chain pulls up stakes, the results can ripple through a community for years. That situation began in 2013, when Safeway announced it was closing its Dominick’s Finer Foods stores in the Chicago market, including three locations in suburban Naperville, Ill.
One of those Dominick’s properties anchored a shopping mall called Fox Run Square. “Grocery stores are probably one of the safest types of anchored shopping center,” says Christine Jeffries, president of the Naperville Development Partnership. But the older centers “tend to get dog-eared toward the end of their life and need reinvestment and modernization. Owners typically say, ‘We can’t sell this property for a reasonable price, because we’re going to pay too much in capital gains.’ So, they just sit on the property.”
Not so with the owners of Fox Run Square. The 35 investors strategized with Rahul Sehgal, chief investment officer at Inland Private Property Corp., and moved forward. Bradford Real Estate Corp. bought the mall for $25.6 million in 2014. By using a 1031 exchange, the investment group was able to defer capital gains taxes. Without it, investors would have held onto the property and tried to renegotiate with the bank, says Sehgal. “Our investors did not have the nearly $30 million of additional capital that the developer spent. Even if they had come up with that kind of money with our assistance, that property would have sat vacant for a long time.”
Beyond benefiting the investors and the buyer, the deal led to the construction of a new Mariano’s grocery store on the Dominick’s site in 2016. Most of the mall’s tenants, primarily small businesses, stayed on, continuing the employment and services they had long provided the community. “It’s about keeping and supporting the small businesses,” Sehgal says. “The benefit to the neighborhood is the survival of some of the smaller tenants. You can’t support them unless you have an anchor, no matter how loyal a base they have.”
1031s offer a viable option for investors interested in transforming underused or vacant commercial properties into multifamily and other residential developments.
The two other former Dominick’s properties in Naperville followed a different trajectory. After both were leased by Albertsons Companies, one was still unoccupied in 2020, and the other only recently became home to an Amazon Fresh store. Jeffries said the dark buildings took a toll on the community. “We started seeing a lot of vacancies [nearby]. Albertsons was paying rent, but there wasn’t the same traffic, the same vibrancy you would have had if a grocery store had occupied there immediately. People want to go where there’s business, where the lights are on.”
In addition to supporting small businesses, 1031 exchanges help communities generate sales tax and property tax, Jeffries explains. “Pre-pandemic, Naperville took in more sales tax than property tax. The more sales tax communities bring in, the less property tax they need to bring in. Any time you can reduce your property tax levy by bringing in more sales, residents are happy.”
Today the mall is thriving. “You can go to that Bradford center early Saturday morning, and people are going to the Ace Hardware, the Mariano’s, the UPS Store. They’re getting their hair done,” Jeffries says. “Every single space is filled.”
