You may have heard us beat the drum in 2014: “Help us save 1031 Exchanges”. Here we are 3 years later with an even more pressing message: “Help us save Commercial Real Estate.” Tax Reform is on the forefront of the new Administration’s agenda and we need to make sure that history doesn’t repeat itself. In 1986 Congress hastily enacted Tax Reform that eliminated passive losses, but the unintended consequences plunged the real estate market and national economy into a deep hole.
To give you a clear idea of what may be on the horizon, let’s answer a few questions.
How do 1031 Exchanges benefit the investor and the economy? Exchanges have been on the books as a part of the Internal Revenue Code in one form or another since 1921. The two primary purposes of the tax law were: 1) to avoid unfair taxation of ongoing investments in property, and 2) to encourage active reinvestment. These purposes are even more relevant today in our global economy than they were in 1921. Section 1031 not only permits efficient use of capital to preserve and manage cash flow, it also encourages U.S. businesses to reinvest in their domestic operations, rather than offshoring business activity.
But doesn’t the government want to get their hands on my tax dollars now? If you think about things logically, 1031 exchanges do stimulate more tax revenue while keeping the real estate market flowing. For example, if you sell an industrial building for $3M and exchange it for an office property that is $4M, two tax increases occur: 1) you will pay higher property taxes at the local level, and 2) hopefully the new property generates more cash flow than the previous property, which means you end up paying more ordinary income tax. Exchanges are win-win for the investor and the government. The investor gets to preserve their wealth by not immediately paying federal capital gains tax, state ordinary income tax, depreciation recapture and potentially a Healthcare surtax, while the government captures higher property taxes and more income tax.
What is currently on the table? Most people are under the impression that because we have a “real estate guy” in the White House, that we won’t have any issues that hinder real estate growth in America. Unfortunately, that may not be the case. Due to the Republican sweep of the elections in November, it is now more likely than ever that Tax Reform legislation will be brought to the table and passed. In June of last year, the House Republicans created a Blueprint for Tax Reform called A Better Way. In and of itself, Tax Reform may not be a bad idea, but the current Blueprint has three particularly illogical proposals which would severely affect the real estate economy. They are as follows:
- Immediate Expensing of All Capital Asset Acquisitions
- Includes land improvements, but not land itself
- Loss of Net Interest Expense Deduction
- Used as an offset to aforementioned immediate expensing
- Elimination of Carried Interest
Legislation is being drafted now and is expected to be introduced in the next few months. If the Blueprint becomes law, there is no guarantee that Section 1031 will be preserved. Farmers, ranchers and investors (commercial and residential) who own and develop land will not be able to expense their land purchases, nor will they be able to exchange their land, buildings and equipment in the same way they can today. Retaining Section 1031 is critical because the provision facilitates deal flow and helps eliminate a “lock-in” effect that would otherwise occur without 1031 Exchanges. Section 1031 also encourages capital formation, increases development and property improvements, and stimulates economic activity. But if we aren’t proactive with these issues Congress may eliminate Section 1031.
How can I help save 1031 exchanges? Stand up and let your voice be heard. We are asking all real estate professionals, investors and anyone interested in saving one of the last great wealth preservation tools, to send a letter/email to some key members of Congress. We are particularly interested in reaching members of the Senate Finance Committee and House Ways and Means Committee.
If you would like further information on what you can do and where to send your message to key members of Congress, please contact the author, Stephen Decker, firstname.lastname@example.org