Congressional members from both parties have discussed reforming the tax code over the coming years. House Republicans, led by Paul Ryan, introduced “A Better Way,” while Democratic Tax reform was introduced under Barack Obama’s FY 2017 Budget Proposal. “A Better Way” and President Trump’s tax proposal, make no mention of repealing Section 1031, and does not include provisions to ensure it remains unchanged if tax reform occurs. This could have a significant impact on the Triple Net Lease market and deal flow if it is not addressed.
President Trump has indicated his desire to simplify the tax code, and introduce immediate expensing of 100% of capital expenditures accompanied by unlimited loss carryforward.1 This will apply to net lease properties, effectively eliminating depreciation expense while simultaneously reducing the tax basis of a property to $0. However, the Blueprint for Tax Reform does not permit expensing of land, and does not address taxable sales that bridge two tax years. The presence of Section 1031 permits single tenant net lease (STNL) investors to exchange their investment property for another investment property across tax years without paying a capital gains tax due to the reinvestment of the previous sale proceeds. The absence of a Section 1031 equivalent in the new tax reform plans, could cause STNL investors to scramble to find a replacement property by year end.
According to Ling and Petrova (2015),2 the possibility of like-kind exchanges leads investors to: actively search for replacement properties and capital assets, have shorter holding periods, have decreased use of leverage, increase capital expenditures from $.27/sf-$.40/sf in replacement properties. All of which positively contribute to the net lease, and general real estate market.
In light of the numerous studies outlining the benefits of 1031 Like-Kind Exchanges, there should be no further discussion about repealing Section 1031 in Congress. Proponents of tax reform, and subsequent repeal of Section 1031, tout the data compiled by Congressional economists stating that the removal of Section 1031 from the IRC would raise $41 Billion in tax revenue over the next 10 years. However, these same advocates fail to address the impact repealing Section 1031 will have on deal flow. Like-Kind exchanges facilitate up to 6% of real estate transactions in the US, and in high-tax states like California, Oregon, and Arizona, the number ranges from 10%-18%.2 The study conducted by the University of Florida and Syracuse University professors, found that 59% of 1031 exchanges in 2011 resulted in sales prices under $1.0 million. While the tax reformists proclaim to hold the interests of small business owners and small-time STNL investors at heart, these findings suggest otherwise.
On a national scale, repealing Section 1031 will have drastic impacts on GDP. A 2015 study conducted by Ernst and Young3 had the following findings:
GDP reduction of $8.1 Billion each year (0.04% decline in 2013 dollars)
Investment reduction of $7.0 Billion (0.18% decline in 2013 dollars)
Labor Income decline of $1.4 Billion (0.11% decline in 2013 dollars)
The implications of repealing, or not addressing Section 1031 are drastic, and Congress needs to analyze the presented case studies in order to ensure they do not detrimentally impact the US economy, and real estate industry.
1IRC Section 1031 Complements the Blueprint for Tax Reform (n.d.): n. pag. Federation of Exchange Accomodators. Web.
2 Ling, David C., and Milena Petrova. The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate. Real Estate Like-Kind Coalition, 22 June 2015. Web.
3“Economic Impact of Repealing Like-Kind Exchange Rules.” (2015): n. pag. Ernst & Young, Nov. 2015. Web. 24 Mar. 2017.