Ari Chazanas Forbes Councils Member
Forbes Business Council
COUNCIL POST| Membership (Fee-Based)
Ari Chazanas is the Founder and CEO of Lotus West Properties, a property management and investment firm based in West Los Angeles.
Eliminating 1031 like-kind exchanges could not only create havoc with property owners and landlords, but it could also impact tenants. In April, President Joe Biden proposed changes to IRS Section 1031 under the American Families Plan (a $1.8 trillion plan), which would affect commercial real estate profits that exceed $500,000.
To understand how these proposed changes would hurt tenants, it helps to understand why 1031 like-kind exchanges matter in the first place.
Defining The Section 1031 Like-Kind Exchange
Section 1031 like-kind exchanges have been used by real estate investors and property owners since 1921. As part of the U.S. Internal Revenue Code, property owners are legally permitted to avoid paying capital gains taxes on sold property and real estate as long as the proceeds from the sale are reinvested within six months of the sale to properties of the same value or greater value. These are also known as “like-kind” properties.
Section 1031 like-kind exchanges play an important role in the economic well-being of the U.S. Research conducted by Ernst and Young estimates they will contribute to 568,000 jobs (download required) and $27.5 billion in labor income to the national economy and generate approximately $7.8 billion in federal, state and local taxes for 2021.
The Proposed Cuts
The proposed cuts to 1031 like-kind exchanges would place a $500,000 limit to gains (and $1 million for married taxpayers with a joint return). The issue is that most commercial real estate sales are significantly higher than the $500,000 proposed limit, which would mean higher tax payments for property owners when the property is sold.
This disincentivizes property owners to sell real estate and could cause them to hold onto buildings for longer. But it doesn’t just affect commercial real estate owners; tenants could be at risk of feeling the effects of these changes as well.
What This Could Mean For Tenants?
The impacts of the caps on Section 1031 like-kind exchanges affect tenants in three ways:
Housing shortages: Developers will have a lot less incentive to build new housing stock, potentially resulting in a serious housing shortage. After all, if real estate investors will have to pay increased taxes on buildings sold, this could cause many of them to look elsewhere for investments. The U.S. is already experiencing the effects of housing shortages across the country — approximately 5.24 million homes short. Additional shortages could only exacerbate the issue.
Decrease in construction quality: The quality of construction could go down significantly due to the decreased value of the real estate. This could ultimately make purchasing properties less desirable for tenants, leaving them unable to find modern housing that meets their standards. Additionally, if landlords do not have the same equity and upside from apartment buildings, they might not reinvest in the units, leaving tenants with substandard and antiquated living conditions. It’s common practice for landlords and property owners to modernize kitchens, bathrooms, and floors when an older tenant vacates. But if the value of the units is decimated, then the motivation (and upside) could go away, leaving tenants worse for wear.
Low-quality rentals and properties: The quality of both new and existing rental housing stock could suffer. Property owners might not feel motivated to spend money on higher-end finishes and update older units if overall the value of those units is substantially less. This would be bad news for tenants, as it could result in paying the same price or more for outdated, low-quality units.
Where Do You Go From Here?
I’ll put it simply: Act now. Do you currently own property that would be eligible for a 1031 exchange? My advice is to not wait to take this opportunity to upgrade that property and defer any capital gains taxes that would come due as a result. I know some of you are thinking it may be worth it to wait and see how this all plays out and determine whether or not these changes to the law will have a major impact on your business. But, in my view, you are doing yourself and your business a disservice if you wait. This could be your last chance to take advantage of the benefits of Section 1031 like-kind exchanges before they’re gone.
Also, be very leery of price manipulation on properties as a response to the changes in the bill. Always remain extremely vigilant in any deal you may enter during this time; there is a lot of concern and worry on the part of property owners. Don’t be caught up in the panic. Make smart and educated decisions to prevent from making a trade too early or possibly too late. There is a tight timeline in place for 1031 exchanges as investors have been given just 45 days from closing a sale to identify replacement property. This could have some investors missing out on all of their potential benefits.
In closing, it makes sense to monitor the progress of this new legislation on 1031 exchanges. The more informed you are, the better off you will be to act accordingly and strike when it makes the most sense for your business.
The information provided here is not investment or tax advice. You should consult with a licensed professional for advice concerning your specific situation.