In recent months, the political spotlight has once again turned to a 100-year-old tax policy: the 1031 exchange. Often referred to as a “loophole” by detractors, a 1031 exchange, in simplest terms, allows for the exchange of one investment property for another and the deferral of capital gains taxes on the transaction. It's one of many policies on the docket for potential change under the new administration.
It's important to stress upfront that this policy creates a tax deferral, not a loophole, and has massive impacts on the economic activity of a wide range of people around the country. I believe any changes to the efficacy of this technique could have wider-ranging consequences than intended.
Here are eight ways the 1031 exchange tax policy benefits the economy, local communities and the U.S. Treasury, as well as some potential implications that significant changes to the policy could have across the country.
1. Mom-and-pop investors are the biggest beneficiaries of the 1031 exchange.
While it’s easy to picture skyline-defining skyscrapers when thinking about real estate, such properties are vastly outnumbered by duplexes, dentist offices and dry cleaners in the United States. The typical property is much more modest than a high-rise, locally owned and valued between $250,000 and $5 million.
Nearly 90% of all properties sold in 2019 transacted in this range, their total value reaching more than $150 billion. So, smaller investors–not corporations–are the prime beneficiaries of 1031 exchanges.
2. Millions of apartment renters benefit from this policy directly.
Apartment transactions accounted for nearly one-third of all 1031 exchange activity in the past decade, roughly twice the share of any other property type. And the average apartment 1031 transaction was 20% smaller than the average for all apartment transactions.
1031 exchanges benefit renters by encouraging the creation or improvement of housing and higher-quality properties and support lower rental rates by increasing housing supply. Exchanges make it more likely that a long-time investor, who may have deferred maintenance and repairs, will sell to new ownership that is able and willing to make the needed investment to improve the property. This means higher-quality rental housing for our nation’s millions of renters
3. The real estate industry represents a large swath of American jobs, and the 1031 Exchange helps to keep it that way.
The real estate industry is at the core of the economy. We interact with the “built” environment every day, and it is inextricably linked to millions of jobs and trillions of dollars of economic output.
While construction is the largest driver to employment and income, ongoing management, sales and operation of buildings support millions of additional jobs across a range of educational backgrounds and trades, including on-site property managers, maintenance crews, skilled tradesmen, accountants, lawyers, bankers, real estate agents, brokers, security officers, landscapers and more.
1031 exchanges support the real estate sector and those dependent on it in a multitude of ways, including encouraging greater overall capital investment, broadening access to business expansion opportunities, and contributing to greater housing supply and affordability.
4. Section 1031 helps individuals and households grow their nest eggs for major life expenses.
Like 401(k)s, 529(b)s and other targeted investment vehicles, section 1031 helps individuals grow their nest eggs in the real estate market tax-free until withdrawal for retirement, college tuition, or other major life events. Eliminating the 1031 would make it more difficult for younger people to build real estate positions for diversification or for important long-term savings needs.
5. This tax policy helps increase activity and increase budgets at the local and state levels to help provide community services.
A repeal or significant change to the 1031 exchange policy would damage public treasuries in states where property tax increases are capped, because such local governments rely on transaction activity to boost transfer-tax revenue and free up existing housing and commercial properties for new buyers. Any policies that disincentivize selling would significantly harm property tax revenue growth, and thus treasury growth, at the local community and state levels.
This could have a significantly negative impact on local government budgets for community needs such as schools for growing populations. Many of the high-population-growth markets where 1031 exchanges are utilized most would be further hurt by diminishment in new housing delivery and lower-than-forecast property tax revenues.
6. 1031 exchanges help local businesses succeed.
Owner-occupiers benefit from the ability to trade up to larger or more suitable spaces without taxation on reinvestment. And even business owners who rent still benefit from the 1031 through lower rental rates from increased supply. Lower rental rates make businesses more viable, allowing lower customer prices or by providing funds for reinvestment.
7. Section 1031 makes it possible to borrow less.
By deferring the tax liability, investors participating in an exchange can allocate all sales proceeds toward the new property, making larger down payments and taking out smaller mortgages. Participants in 1031 exchanges average significantly lower debt ratios than others. The average borrowing ratio during the past decade was 30% for 1031 exchanges versus 43% for all deals.
When investors borrow less, they have greater capacity to borrow later to invest in building improvements and create additional value for renters and the community.
And by supporting lower leverage ratios and less borrowing from banks, 1031 exchanges also help prevent the types of market destabilization that can require costly policy responses as we have seen in recent years, ultimately saving the taxpayer money.
8. The public treasury ultimately earns more, because property owners realize less income tax shelter in real estate.
Most participants in 1031 exchanges ultimately sell their interests in taxable transactions, at which point deferred taxes are owed in full. In fact, exchanges are best thought of as simply an extension of the due date for capital gains taxes by the government to encourage expanded real estate investment, particularly by smaller owners and operators.
By way of section 1031, the public treasury ultimately earns more, because property owners realize less income tax shelter, exposing more income to taxation at higher tax rates. Typically, following an exchange, an investor’s depreciable investment basis drops as a ratio of the new overall value.
No matter an individual’s perspective, there are many ways that this tax policy has quietly become a key part of our economy. Just like major changes to things like 401(k)s or to our health care system are considered at a grand scale for their potential ripple effects, this policy needs to be evaluated from multiple facets before treating it like a simple line-item budgetary issue.
Mark Hamilton is CEO and co-founder of Hamilton Zanze Real Estate Investments.