Growers have often used 1031 exchanges to defer taxes on ag land purchases. File photo.
Written by Edward Smith
The world of real estate tax law may seem convoluted and isolated, but some fear a proposal from presidential candidate Joe Biden has the potential to upend a delicate balance of investments, jobs and rent — while others feel closing a loophole has been a longtime coming.
The proposal to end 1031 “like-kind” exchanges isn’t the first.
In 1921, tax law was changed to allow property owners to sell property and reinvest that money into other real estate similar to the original investment and defer the capital gains tax should the original property have appreciated in value. The 1031 exchange— named after the Internal Revenue Code that changed the law — allows the deferment of capital gains continuously so as long as the sale and the purchase of the next property meet stringent laws and timelines.
What the 1031 allows is for business owners to build their portfolio, says Robert Wiebe, partner with Wiebe Hinton Hambalek, LLP, an accounting firm in Fresno.
Property owners can sell their existing facility and trade into another facility that meets their needs, Wiebe said, whether that be a better location, more efficient size or more updated technology.
“If they didn’t have the 1031, they’d have to pay the tax now and they’d have less cash to go reinvest in the replacement property,” Wiebe said.
The Biden plan would eliminate the 1031 exchange for real estate investors making over $400,000 in annual income, using the income to finance child and elderly care.
The Joint Committee on Taxation projects that $51 billion between 2019 and 2023 will be deferred.
Since its inception, the exchange has evolved from its original intent, says Steve Wamhoff, director of federal tax policy for the Institute on Taxation and Economic Policy.
The exchange was originally created out of the view that it was unfair to tax a gain when an individual hasn’t yet “cashed out,” according to the Senate Finance Committee.
The code has become far more complicated and many investors have used it to avoid paying taxes indefinitely. The capital gains on a property purchased with deferred 1031 money could potentially never be paid, said Wamhoff, thus becoming a subsidy favoring real estate investment more than other types of business.
“There’s all kinds of ways you can make money and get rich, but usually, when you make make money and get rich, you have to pay money on the income,” said Wamhoff.
The rules on what is considered “like-kind” have also loosened.
Under the letter of the law, property eligible for capital gains deferment has to be in the same class.
“The rules are complex and frequently misinterpreted,” said Wiebe. The definition of “like-kind” can be as strict as to say that farmland with trees on it is classified differently than empty farmland.
In the case of farmland, many farmers have utilized those exchanges to leave an industry beset by trade and water disputes as well as environmental reforms, according to Landon Fernandes, a real estate broker with Graham and Associates, and a dairy farmer in Tulare.
Fernandes has sold a lot of land for farmers who feel it’s their time to get out of the business and invest in commercial real estate, whether it be retail, multi-family or industrial warehouses, said Fernandes.
1031 has become a major incentive to improve properties. In real estate, brokers often urge property owners to improve the land by investing those profits back into the real estate as capital projects, raising the value of the property, said Sullivan Grosz, broker with Pearson Realty. Paying capital gains, which can be as high as 30%, reduces the ability to produce by that much.
“If we lost this, it would pull the rug out from the real estate industry at a time the industry is reeling from the pandemic,” said Bobby Fena, senior vice president with Colliers International.
In 2015, the Senate Finance Committee estimated that eliminating the exchange would shrink the economy by $13.1 billion annually. Investment would decrease by $7 billion in the long-run and labor income would fall by $1.4 billion. This most recent estimation does not include changes made to the law in 2017 that excluded equipment from 1031 exchanges.
Fena says it’s a little early to tell how it will affect real estate in the Central Valley, but Wiebe feels the lack of liquidity could affect rents as well as hiring.
Many retailers and restaurants in particular are asking for rent relief. Landlords may want to get out of properties and sell to buyers with more cash. Losing 30% inhibits a property owner’s ability to provide those rent reliefs.
But there is no guarantee that relief be given to renters, says Wamhoff. The beneficiaries of Section 1031 are investors and tax breaks for wealthy investors are not a way to help the down and out, he said. Congress can provide relief directly if there’s an issue.
But others still feel the benefits outweigh the consequences.
“If they pass this law, they’re going to accelerate some tax in the short term, but in the long term, it’s going to have a lot smaller effect,” Wiebe said.