Like-Kind Exchanges, Property Development and Improvement
May 11, 2021
By Joseph Rubin
Like-kind exchanges, as defined in IRC Sec. 1031 of the IRS Tax Code, have been widely used in the past few years as real estate values have increased. The rule enables the full proceeds of a multifamily or commercial property sale to be used to acquire and enhance other properties. In April, the Biden Administration released the American Families Plan, which would limit the deferral of capital gains on the sale of property to $500,000. Anticipating the potential repeal of IRC Sec. 1031 based on remarks made on the campaign trail, a broad coalition of real estate organizations formed to examine the impact of that action. The group wrote a letter to the leaders of the Senate Committee on Finance and the House Committee on Ways and Means on March 16, 2021 (the “Letter to Congress”) explaining the benefits of like-kind exchanges and the possible economic detriment if the rule were to be repealed. The letter was, in part, based on studies by David Ling of the University of Florida and Milena Petrova of Syracuse University,1 as well as an economic study of like-kind exchanges conducted by EY.2
Before summarizing some of the key points being offered in support of real estate like-kind exchanges, a few facts uncovered by the studies help to better demonstrate how these exchanges have been used. Ling and Petrova looked at several transaction databases, including over 800,000 transactions tracked by CoStar from January 2010 through June 2020, and found that between 10% and 20% of all real estate sales involved a like-kind exchange. Moreover, the data showed that the use of like-kind exchanges has grown in the last decade, likely reflecting a period of increasing property values, and therefore these exchanges have become a critical strategy in preserving investment capital. Ling and Petrova also found that the median sales price of exchanged properties was $575,000 and 75% of all the sales were priced under $1.5 million, indicating that IRC Sec. 1031 primarily benefits small businesses and real estate owners rather than larger institutional players.
Ling and Petrova concluded that like-kind exchanges were most often used for multifamily properties, and data published by Mountain Dell3 showed that multifamily properties comprise just over 50% of all exchanges in recent years. As such, the exchanges keep higher amounts of capital within the housing sector where the shortage of affordable and workforce housing is of great concern. While many think that investors use IRC Sec. 1031 to repeatedly defer gains tax, the Ling and Petrova study found that 88% of replacement investments in like-kind exchanges are sold outright. In other words, most investors do not use an on-going series of exchanges and tax deferrals; the capital gains taxes are most often paid in the next recirculation of investment capital. Moreover, they concluded that the second sale generates 19% more tax revenue than had the gains tax been collected upon the original sale.
The studies, Letter to Congress, and other white papers shared the following:
Promotes Capital Efficiency and Property Enhancement: Taxing a gain on the sale of an asset reduces the net proceeds of the sale and the capital available to be reinvested in purchasing and improving other assets. As Ling and Petrova found, this is particularly true in real estate because in many cases the owners of a property have exhausted the capital available for continued improvements and are holding onto the property solely because they have been dis-incentivized from a sale by the gains tax. This is often referred to as the “lock-in” effect; a pattern where the property is not sufficiently improved, reducing its performance potential and value in the marketplace, and contributing less to the overall well-being of the community. In contrast, a like-kind exchange with gains tax deferral swaps older, often disinterested capital with fresh capital. The new capital is often eager to invest to improve the property, making it more attractive to tenants and enhancing the surrounding community. Such new investment improves the marketability of what might have been illiquid holdings, particularly for smaller, non-institutional properties. The EY study found that without the like-kind exchange rules, properties would be held 37% longer, preventing capital from recirculating toward new investments and property improvements.
Reduces Investment Risk Through Lower Leverage: Ling and Petrova also found that “investors in like-kind exchanges use less leverage than ordinary investors to acquire replacement properties.” The replacement properties they tracked had lower loan-to-value ratios than typical real estate investors. Loan-to-value ratios on replacement properties averaged 30% compared to 43% for non-exchange transactions, or 30% less leverage. This is often achieved because the full amount of proceeds from the sale of the original property is available to fund equity in the replacement property. Lower leverage reduces the overall risk in the real estate sector and protects investors, and their lenders, from temporary downturns that may impact the valuation of the properties.
Increases Investment in the Community: Selling a property in a like-kind exchange brings fresh capital into the original property and the replacement property, and likely induces capital expenditures in both. The transactions and the on-going investments in the assets creates jobs for the many services and trades that support the real estate industry. The EY study estimated that like-kind exchanges support more than 500,000 jobs. In addition, like-kind exchanges enable small businesses that own their facilities, including farms, to move to better facilities or land parcels, or follow their customers as they migrate locally and nationally. Without the deferral of gains taxes, the after-tax proceeds from the sale of the original property would be insufficient for the business to buy a replacement facility, restricting its ability to move and grow.
Benefits Retirements: Using like-kind exchanges, family business owners, farmers, and long-term real estate owners are able to sell assets without depleting retirement savings. These private businesses often don’t have the benefit of corporate retirement plans and rely on continuing income from the real estate. The ability to transfer ownership from one property to another more productive asset enables retirement asset values and cash flow to be preserved.
As the pandemic recedes, many owners and investment companies will seek investment capital to repurpose, reconfigure and improve properties. The deferral of capital gains tax through like-kind exchanges may accelerate the transfer of assets to new, more highly capitalized ownership that would enable these improvements.
1The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate, David C. Lang and Milena Petrova, June 22, 2015; The Tax and Economic Impacts of Section 1031 Like-Kind Exchanges in Real Estate, David C. Lang and Milena Petrova, October 2020
2Economic Impact of Repealing Like-Kind Exchange Rules, EY, November 2015
31031 Turns 100: Industry Insights on the DST Market, Phoenix American Trends Outlook Report, March 2021