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1031 Like-Kind exchanges: Breaking it down for IREM members

If you ask anyone outside the industry what the typical real estate investor might look like, you’re liable to get a description of a well-dressed figure perched atop an empire of gleaming glass office towers. The descriptions would be colorful, and they would be mostly wrong.

“The large corporations make the major deals and get the big headlines,” says 2021 IREM president Chip Watts, CPM®, “but the vast majority of players are smaller investors.”

This is a critical distinction to make at this time, since a major vehicle for both personal income and community development is the 1031 like-kind exchange, which is currently facing severe government scrutiny. You’ve read the headlines. Now here are the facts.

The back story

Major infrastructure proposals, under the umbrella title of The American Jobs Plan, are coming from the White House, including $2 trillion for physical upgrades, the types we usually associate with infrastructure: bridges, tunnels, airports and the like. In addition, the Biden administration proposes what we might call soft infrastructure programs under the heading of The American Families Plan. This would allocate another $1.8 trillion for such initiatives as paid family medical leave, free tuition to community colleges, and the recruitment of more teachers.

Of course, such massive expenditures come with equally big “pay-fors,” and the idea is to accomplish that, at least in part, is by raising the corporate tax rate from 21 to 28 percent, hiking taxes on people making more than $400,000, doubling the capital gains tax rate and eliminating  tax deferrals on 1031 like-kind exchanges for gains greater than $500,000.

Let’s take a look at the intent of the 1031 exchange, which is, as Chip Watts explains, “to dispose of one asset and acquire another of similar type without incurring a capital gain. It should be noted here that this is not a tax loophole. It’s a deferral. And that’s an important point to understand.”

Watts explains that an investor could create a chain of exchanges, sell each one at increasing value and re-invest the proceeds in another property. “Ultimately, under the current law, you wouldn’t be taxed until you actually sell the last property in the chain through a conventional sale.” There are also time limits on the transactions. Follow-up properties must be identified within 45 days and the exchange completed within six months.

The issue around 1031 exchanges

Whether the investor is a well-heeled scion of real estate or your next door neighbor, the loss of the 1031 exchange will break the domino effect of job creation--primarily construction jobs, but ancillary positions as well--and the revitalization of both properties and communities.

According to a report issued recently by EY, “1031 exchanges will support 568,000 jobs and $27.5 billion of labor income in the United States during 2021.” The firm points to the likely underestimation of that figure and calculates that job growth and labor income could, therefore, be as much as “710,000 and $34.4 billion, respectively.”

In our conversations with Chip, he told of a local Birmingham, AL, investor who parlayed that chain of exchanges of increasing value into no fewer than eight affordable housing units, a much-needed community enhancement--and in one very real aspect, a human infrastructure improvement--that would not have been possible if the gains on the first sale were taxed as capital gains. Other investors have used the vehicle to fund entry into Opportunity Zones, where the upgrade of a property also raises the outlook of a struggling local community.

EY says like-kind exchanges will contribute $55.3 billion to the United States GDP this year. And again, a likely underestimation of those figures could boost the GDP contribution to as much as $69.1 billion.

Lastly, for those who still see the 1031 exchange as a tax loophole, EY predicts that these transactions will generate nearly $8 billion in federal, state and local taxes during 2021. (It’s interesting to note that, even with the embedded deadlines, tax-exchange buyers are rushing to complete their deals now, before the close of the year and the start of a new tax year on January 1, 2022.)

The fate of the 1031 like-kind exchange has been a discussion for years in political circles. In private arenas, however, it’s seen for what it is, a provider of jobs, wealth and community stability, not just for wealthy real estate investors, but for all taxpayers.

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