by Charley Babb
In their heyday of the 1970s and 1980s, citizens band (CB) radio users utilized the “ten code” as part of their style of communication. In CB radio parlance, “10-4” means “affirmative” and “10-7” means “out of service.” Most seasoned commercial real estate professionals are familiar with the 1031 exchange program, which derives its name from that section of the Internal Revenue Service Code. So, recent rumblings in Washington, DC, could result in this highly popular and productive investment strategy to be rendered out of service.
1031 exchanges allow for the deferral of federal income taxes upon the exchange of one “like-kind” asset for another, provided certain conditions are met. The investment basis from the prior asset is transferred to the newly acquired asset and the taxable gain is deferred until the sale of the subsequent asset is realized. The practice is not limited to real estate though it has enjoyed a history of successful utilization with real estate assets for more than 90 years.
Recently, several congressional tax-reform proposals have called for the repeal of Section 1031 in an effort to raise federal tax revenues. In addition, the Obama administration has put forth budget proposals to place limits on exchanges. Several experts believe that, if successful, the removal of the program would have negative effects on the commercial real estate marketplace.
As is often the case, congressional goals of raising revenues by levying taxes are based upon the assumption that investment behavior will remain the same in spite of the proposed changes and that the deferred taxes in this case will be collected in the present. However, this is a very naïve view. According to Keith Lampi, President and COO of Chicago-based Inland Private Capital Corp., “…take that provision away and property owners would hang onto properties longer, it would freeze liquidity and in general have a negative effect on the real estate industry.” His firm alone accounted for about $1 billion in acquisitions as a result of their 1031 programs.
A recent study conducted by Ernst & Young concluded that “repeal would slow economic growth, and its overall impact would result in a $26 billion drop in annual GDP.” Like-kind exchanges encourage investment and contribute significant federal tax revenue over the long run. For the tax reformers to assume that the repeal of the 1031 exchange program will have an immediate positive effect on revenue is so short-sighted that it is foolishness.
Since 2010, there has been a nearly 30-percent increase in annual exchange transactions. One of the reasons for the increase in exchanges is a strong uptick in baby-boomer investors moving from more management-intensive real estate assets into single-tenant NNN properties. The capital markets are quite efficient in providing debt capital for these transactions and this also makes for high transaction volume. It would be a shame to see the real estate market liquidity for these transactions disappear due to the misguided reforms contemplated inside the beltway of Washington, DC.
Metropolitan Capital Advisors seeks to assist its clients with their commercial real estate financing needs whether it be a construction loan, acquisition debt, permanent mortgage or an equity placement. We welcome the prospect to evaluate your opportunities with you and bring unbiased solutions and recommendations. The author, Charley Babb, is a Senior Director, Co-Principal of MCA’s Denver office. Charley can be reached at 303-647-9032 or www.metcapital.com.