1031 Exchanges Will Be Around for Another Century
In 1921, Congress enacted the original law establishing “non-recognition” of income in a property transaction. Put simply, the government established the legal foundation for not recognizing a taxpayer’s capital gain as being taxable, under certain conditions. This law migrated through three different sections of the U.S. codes before settling in 1954 on §1031 of the Internal Revenue Code. Since that time, “1031” has become synonymous with conducting a tax-deferred sale of property.
The core rationale for non-recognition of gain in a §1031 exchange—continuation of investment—is sensible and straightforward, dating back to a 1934 report from the House Ways and Means Committee:
[I]f the taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit. The calculation of profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a fair market value.[i]
You may wonder why we use the term “exchange” to describe selling one property and buying another. After all, in today’s typical §1031 exchange, there is no direct trading of assets. The original rules contemplated transactions in which two or more parties literally exchanged assets. These early transactions had quaint names like “three corner exchange”. In 1979 the Ninth Circuit Court of Appeals, true to form, invented a new form of exchange: a transaction now could qualify for non-recognition treatment, even if the taxpayer delayed acquiring the replacement property for several months.[ii] Congress responded to the Ninth Circuit’s judicial legislation by enacting the familiar deadlines we know today: 45 days to identify and 180 days to close. §1031 exchanges became highly standardized and reliable transactions.
The United States now has the most robust real estate market in the world. Based on combined data from NAREIT and Zillow, it is estimated that all real property (commercial and residential) in the U.S. exceeds $50 trillion![iii] That value depends on the transferability of assets and the freedom to trade properties without triggering undue taxation. While this author questions the morality of any capital gains tax on any asset, it would be particularly egregious if homeowners could not trade up to better homes, or investors could not trade their rental properties, without deferring the highly punitive tax on capital gains. Without §1031 exchanges, all U.S. real estate values would suffer.
Industry experts agree. In a recent analysis by Ernst & Young, the firm determined that a repeal of IRC §1031 would[iv]:
- result in less federal revenue
- shrink the U.S. economy, up to $13.1 billion annually
- discourage investment
- negatively impact the overall economy, with an unfair concentration in certain industries
- unfairly burden certain businesses and taxpayers
- be at cross-purposes with the goals of tax reform.
It seems that every few years, some politician rediscovers §1031 exchanges as a rallying cry to fill this supposed “loophole” in the tax code for all of us greedy landlords and real estate investors. In 2018, such zealots were successful in limiting §1031 exchanges to real estate, to the exclusion machinery, cattle, equipment, etc. Most recently, members of the Biden campaign (and now administration) have been focused on this issue enough to garner significant attention. Whether these folks are sincere—or merely playing to the far tax-and-spend end of their base—we may never know. Nevertheless, the recent election drama and transfer of control in the Senate has given anti-1031ers more hope than in years past.
Fortunately for the rest of us, §1031 exchanges are not going away. The real estate market is too important, employment in real estate is too large and many members of Congress (both Republicans and Democrats) rely on §1031 to conduct their own tax-deferred sales of business and investment properties. Not to mention the demographic tidal wave of voting Baby Boomers, living in blue states, who want to exchange into passive real estate. The new leadership may chip away at the step-up in capital gains upon death, but we are not worried about §1031 exchanges.
And we should know—our name is 1031 Capital Solutions.
[i] H.R. Rep. No. 73-704, at 13 (1934), from Borden, Bradley T. Tax-Free Like-Kind Exchanges. Kingston: Civic Research Institute, 2015, at 1.2
[ii] Starker v. United States, 602 F.2d 1341 (9th Cir. 1979)
[iii] https://www.reit.com/data-research/research/nareit-research/estimating-size-commercial-real-estate-market-us and https://www.worldpropertyjournal.com/real-estate-news/united-states/los-angeles-real-estate-news/real-estate-news-zillow-housing-data-for-2020-combined-housing-market-value-in-2020-us-gdp-china-gdp-rising-home-value-data-11769.php
There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to sell any securities. DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney.
1031 Capital Solutions does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Insurance products offered through Concorde Insurance Agency, Inc. (CIA) 1031 Capital Solutions is independent of CIS, CAM and CIA.
This information is for educational purposes only and does not constitute direct investment advice or a direct offer to buy or sell an investment, and is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor. The views of this material are those solely of the author and do not necessarily represent the views of their affiliates.
Investing in real estate and 1031 exchange replacement properties may involve significant risks. These risks include, but are not limited to, lack of liquidity, limited transferability, conflicts of interest, loss of entire investment principal, declining market values, tenant vacancies, and real estate fluctuations based upon a number of factors, which may include changes in interest rates, laws, operating expenses, insurance costs and tenant turnover. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment.
Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Insurance products offered through Concorde Insurance Agency, Inc. (CIA). 1031 Capital Solutions is independent of CIS, CAM and CIA.