Biden's Latest Proposal Puts CRE Tax Break In Political Crosshairs Once More
Former Vice President Joe Biden would do away with a popular real estate tax-shielding program to help fund a $775B childcare and elderly care plan he is proposing in his bid for the White House.
The proposal would eliminate like-kind exchanges, including the darling of real estate investors, the 1031 exchange program, which has been used by investors for decades to avoid paying capital gains taxes on real estate sales.
“[1031 exchanges are] a major loophole that just makes no sense,” said Chuck Marr, the senior director of federal tax policy at nonpartisan fiscal think tank Center for Budget and Policy Priorities. “This is way past its due date."
But proponents say revoking the like-kind exchange system, which is nearly 100 years old, is too risky today as commercial real estate values take a hit during the coronavirus pandemic, and could only exacerbate economic problems.
“The last thing our economy needs right now is to de-incentivize commercial real estate transactions and development under the hope of higher tax revenue,” said Chad Knibbe, president of Texas commercial real estate brokerage Foresite Commercial Real Estate, in an email to Bisnow. "The reality would be lower property values, lower tax revenue for local governments and reduced transaction velocity."
The 1031 program acts as a lubricant to the commercial real estate sales market, proponents say. But that market has all but frozen in recent weeks due to the pandemic. Nationally, investment sales plunged in the second quarter, dropping nearly 70% year-over-year, according to recent CoStar data.
Biden’s plan calls for phasing out the 1031 exchange program for investors whose incomes exceed $400K per year. With the added tax revenue, Biden would fund a $775B program directing a number of benefits, including tax credits or direct subsidies, to help pay for childcare for families with children younger than 13, CNBC reports. The Democratic nominee would allocate $450B over a decade to aid in elder care and lower the waiting list for Medicaid services.
Detractors like Marr say the 1031 exchange program does little to help average taxpayers, while its backers, including the real estate industry's powerful lobby, argue it mostly helps small-business owners, farmers and families while spurring construction and other real estate jobs.
Investment Property Exchange Services Inc. General Counsel Suzanne Goldstein Baker, who also is the past president of the 1031 industry group Federation of Exchange Accommodators, said the median value of properties traded by exchanges in the country is $500K or less. The average fair market value of those assets sold was $7M, according to the National Association of Realtors, a far cry from the prices that skyscrapers or major distribution centers fetch in the market.
“I think there's this image in your head of this Wall Street tycoon wearing this suit and smoking cigars, and that's not true. The vast vast vast majority is mom-and-pop investors,” said Drew Reynolds, the chief investment officer of Realized, an Austin, Texas-based wealth management firm that advises 1031 exchange investors. “It's a lot of money, don't get me wrong. But it's not the Lifestyles of the Rich and Famous.”
Despite the real estate industry's data, Marr and other critics say 1031 exchanges ultimately help wealthy investors avoid paying capital gains taxes, at times in perpetuity since investors can continue to roll into one sale after another under the program. The total amount of equity raised to invest in like-kind exchange real estate grew from a 2010 low point of $170M to an estimated $2.4B in 2018, according to the Alternative & Direct Investment Securities Association.
“Most mainstream working-class Americans aren't trading $500K [properties],” Marr said. “If someone sells Apple and buys Amazon, they're going to pay taxes. There's no difference with buildings.”
Many opponents of Biden’s proposal benefit from the tax-avoidance baked into 1031 program. They contend that doing away with the tax benefit, which has been threatened many times before during its nearly 100-year history, would take more away from the economy more than the taxes collected would add, especially at a time when commercial real estate values are already in a crisis.
Eliminating the exchange could cut into the U.S.' annual gross domestic product by $8B, according to a 2015 study by EY, which was commissioned by the Section 1031 Like-Kind Exchange Coalition, a group composed of 12 industry associations that would be impacted by the repeal of like-kind exchanges. Repeal would create a ripple effect of declining revenues across industries tied to commercial real estate, including construction, engineering and trucking, according to the report.
Eliminating 1031 exchanges would further chill commercial real estate transactions, because investors would gravitate to other instruments, such as the stock market, CCIM Chief Economist K.C. Conway said.
On average, property values could drop 20% and as much as 27% in states with high tax rates, according to a 2015 study conducted by two Syracuse University professors, funded by the Real Estate Roundtable and the Alternative & Direct Investment Securities Association, two prominent commercial real estate lobbying groups. It was drafted as Republicans in Congress debated eliminating like-kind exchanges in the Tax Cuts and Jobs Act of 2017.
Ultimately, the policy was preserved for real estate when the bill reached President Donald Trump's desk.
“I think we would see some money leaving real estate, simply because right now if somebody sells a piece of real estate, they can avoid gain by going back into real estate,” said Brooklyn Law School professor Bradley Borden, who teaches tax law.
Fewer real estate transactions would mean less revenue for local governments across the country, especially at a time when the coronavirus pandemic is already wreaking financial havoc, Reynolds said.
“Property taxes are directly related to property value,” he said. "And so property values are down 20% if nothing else changes, then every municipality has 20% less tax value. So you're funding the daycares at the expense of the school system."
Banks already are facing issues in the pandemic with their commercial real estate loan portfolios. According to the Mortgage Bankers Association, outstanding commercial and multifamily debt across the globe exceeded $3.7 trillion at the end of the first quarter of 2020. At the start of the 2008 Great Recession, that debt was more than $1.5 trillion, according to data compiled by the Federal Reserve Bank of St. Louis.
“We already have a CRE concentration problem in the banks. All of these [loan] values are declining right now,” Conway said.
But not all CRE professionals subscribe to the idea that commercial real estate values influenced by 1031 exchanges are a good thing. Nelson Management Group President Robert Nelson, who owns more than 3,000 apartments in New York City, said his attitude toward 1031 exchanges is “ambivalent.”
Investors who intended to put their capital gains into 1031 exchanges must select and close on a new property within 180 days in order to avoid taxes. That aggressive timeline has artificially inflated property values, Nelson said.
“On the one hand, it creates an investment vehicle that stimulates the local economy and provides a tax base for the municipalities," Nelson said. "But on the flip side, it also creates a situation where investment properties are more expensive.”
“If I'm on the sales side, which for the most part these days and for most of my career I haven't been, I guess I'm going to be happy about that,” he said. “When I'm out there looking for investment opportunities, I know that because of the world of 1031s ... the prices that a seller can get are sometimes inflated because of 1031 buyers."