There is little doubt that the commercial real estate market will be profoundly affected by the results of the upcoming presidential election and the accompanying political developments. Both presidential contenders and government officials have talked about changing the current tax structure for years. Potential revisions to Section 1031 of the Internal Revenue Code (IRC) and their long-term implications for the commercial real estate industry and the economy are among the most significant recent developments. When property owners sell an asset and reinvest the proceeds into an identical asset, they are exempt from paying taxes on the sale proceeds under Section 1031, also known as a 1031 exchange. The tax liability is postponed rather than canceled. These taxes are ultimately the property owner’s responsibility, who will have to cover them upon the sale of the property.
The potential for substantial tax savings presented by 1031 exchanges has contributed to its widespread use in the real estate industry, even though the federal government has been considering for years the possibility of doing away with the program. Or, at the very least, being investigated by legislators and given significant consideration as future changes are being contemplated as options.
Both major party candidates running for president in this year’s election have advocated for changes to the country’s existing tax structure. Still, neither has specified what impact these reforms would have on Section 1031 if implemented. Some believe the government might eliminate the Section 1031 regulations to fund alternative tax or expenditure initiatives. The final authorizations and decisions made by Congress will eventually significantly impact the course of tax reform. If Section 1031 were to be changed or eliminated, it would substantially impact the real estate market.
While Section 1031 exchanges might not directly generate a lot of tax income, they do stimulate a lot of business activity, which could end up being worth far more to the government than any tax money it could miss. According to “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate,” research by David C. Ling and Milena Petrova:
“The elimination of real estate exchanges will likely lead to a decrease in prices in the short-run, followed by an increase in rents in the longer run. These negative effects will be more pronounced in high tax states. Elimination will also likely produce a decrease in real estate investment, increase in investment holding periods, and an increase in the use of leverage.”
Mortgage brokers, lenders, and banks are kept busy by the increased volume of transactions made possible by 1031 exchanges, and the ensuing origination fees help fuel economic activity. They also work for various related service providers, such as appraisers, surveyors, phase-one firms, inspection firms, etc. As a result of these 1031 exchanges, many different industries are gaining momentum, which also impacts the renter market.
Due to the income tax deferral provided by Section 1031 exchanges, investors can take on risk at lower rates of return. Take, for example, the 1031 acquisition of a rented $2 million house. If the property generates $100,000 in annual income, the owner will owe income tax, but at a lower rate than they would owe if they hadn’t used a 1031 exchange. As opposed to a one-time capital gain taxable event from the sale of the property, this provides a yearly taxable income stream that results in ongoing monetary investment in our economy.
Some businesses can expand their footprint because of decreased capitalization rates and rentals for tenants. The expansion of these businesses is essential to the economy’s well-being because the retail sector is responsible for a significant portion of the nation’s building and development and the creation of new jobs. The growth of the economy can be somewhat attributed to these several variables.
If investors are forced to pay more to meet their profit expectations due to reforms made to Section 1031, rent hikes may be unavoidable. If rents continue to rise, retail establishments may be compelled to put their expansion plans on hold. It could have far-reaching repercussions for various industries, including retail, office, medical, and others. When businesses reduce or stop expanding, fewer new buildings are constructed, fewer new employment is created, and slower economic growth.
All of these factors underscore how important it is for all areas of the real estate market to be aware of the potential implications of repealing or amendment of Section 1031. All industries must work together to preserve Section 1031 regardless of the outcome of the impending midterm elections in November. These elections will take place in November. There is a possibility that the market for commercial real estate could experience significant upheavals, which will necessitate a concentrated effort by the real estate industry to battle against it.
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