Article review of The Tax and Economic Impacts of Section 1031 Like-Kind Exchanges in Real Estate
Section 1031 of the Internal Revenue Code has permitted taxpayers to defer the recognition of taxable gains on the disposition of business-use or investment assets since 1921. Although the legislation commonly known as the Tax Cuts and Jobs Act (TCJA) of 2017 repealed exchanges for personal property, TCJA maintained their use for real property. The ongoing need for revenue to fund government expenses and new legislative initiatives has once again generated increased discussion of the benefits and costs of like-kind exchanges of real estate. Against this backdrop, we were approached last summer by members of the Real Estate Research Consortium and asked to update our analysis of real estate like-kind exchanges that we first produced in 2015.
A like-kind exchange is, strictly speaking, a tax deferral technique. The taxpayer’s basis in the replacement property is set equal to the transaction price of the replacement property minus the gain deferred on the disposition of the relinquished property. The table below shows the major difference between a taxable sale/purchase and a like-kind exchange. Assume a taxpayer purchased an office building 10 years ago for $1,000 using all cash. Eighty percent of the purchase price represented depreciable building improvements; 20% represented non-depreciable land. Current tax law allows taxpayers to depreciate (“recover”) the cost of the non-residential building improvements using straight-line depreciation and a 39-year cost recovery period. This has produced an annual tax deduction of $20.5 for a total of $205 over ten years. The current tax basis in the property is therefore $795. The current market value of the property is $1,500.
- 10 years ago purchase price: $1000
- Annual depreciation deduction: $20.5 = ($1,000 x 0.80)/39
- Total depreciation over 10 yrs: $205
- Current tax basis: $795 = $1,000 – $205
- Current market value: $1,500
Assume the investor has decided to dispose of the property and has identified a replacement property with, for simplicity, a value of $1,500. The replacement property will also be financed with all cash. If the investor disposes of the relinquished property in a fully taxable sale, she will recognize a taxable gain of $705, of which $500 represent nominal price appreciation that would be taxed at a federal rate of 20%. The portion of the taxable gain that represent the recapture of depreciation deductions ($205) would be taxed at a federal tax rate of 25%. Thus, a fully taxable sale would produce a federal income tax liability of $151 ($100 + $51) in the year of the sale. This reduces the amount of cash the taxpayer has available to invest in the replacement property. The investor’s tax basis in the replacement property would be $1,500, which would produce a depreciation deduction of $30.8 over the next 39 years assuming 80% of the $1,500 price represents building improvements.
A second option is to exchange into the $1,500 replacement property. The advantage of this strategy is that the recognition of the $705 taxable gain would be deferred. This occurs whenever the value of the replacement property is equal to or greater than the value of the relinquished property. This immediate benefit of an exchange in often the focus of investors. However, the disadvantage of the exchange strategy is that the investor’s tax basis in the replacement property is $795 (not $1,500) and the annual deprecation deduction would remain $20.5 for 29 years (39 – 10). This depreciation deduction is 33% less than the $30.8 deduction that would be available if the investor chose to acquire the replacement property using a sale/purchase strategy. Moreover, if and when the replacement property is disposed of in a fully taxable sale, the investor would have to pay the $151 in taxes that was deferred in the year of the exchange in addition to paying taxes on any price appreciation that occurs or depreciation that is taken after acquiring the replacement property.
Replacement Property Options
- Sell & purchase $1,500 replacement property
- Current sale price: $1,500
- Current tax basis: $795
- Total taxable gain: $705
- Tax on appreciation: (@20%) $100
- Tax on depreciation: (@25%) $51
- Total tax at sale: $151
- Tax basis in replacement property: $1,500
- Annual depreciation deduction: $30.8
- Exchange into $1,500 replacement property
- Total tax in exchange year: $0
- Tax basis in replacement property: $795
- Annual depreciation deduction: $20.5
The present value of income tax deferral associated with the exchange is a function of the magnitude of the deferred capital gain and depreciation recapture taxes, the expected length of time before the replacement property is disposed of in a fully taxable sale, and the discount rate applied to the incrementally higher taxes paid in the years after the exchange. All else equal, taxpayers should exchange into the replacement property, instead of selling the relinquished property and purchasing the replacement property, if the present value of the exchange strategy exceeds the present value of the sale-purchase strategy. It is not a strictly positive endeavor. The exchange offers tax benefits and requires tax offsets.
The tax deferral benefit is typically the focus of discussion concerning the tax advantages of like-kind exchanges. However, as the example above illustrates, the value of immediate tax deferral is significantly offset by three disadvantages of using an exchange to acquire a replacement property instead of a taxable sale-purchase strategy. The first disadvantage is that the tax basis in the replacement property is set equal to the taxpayer’s basis in the relinquished property (i.e., the “exchange” basis). This exchange basis carried forward from the relinquished property into the replacement property is depreciated over the remaining cost recovery period of the relinquished property. This ensures that the annual depreciation deduction on the replacement property is equal to the deduction that would be taken had the taxpayer-maintained ownership of the relinquished property. If nominal price appreciation has occurred since the acquisition of the relinquished property, the annual depreciation deduction after the exchange is less than it would be if a sale-purchase strategy were used to acquire the replacement property.
Second, the depreciation recapture portion of the total gain on a fully taxable sale of the replacement property is equal to the amount of depreciation recapture income originally deferred by the exchange, plus the tax depreciation deducted since the exchange. This increased depreciation recapture tax under an exchange further reduces the incremental benefit of an exchange.
Finally, because the deferred gain associated with an exchange reduces the tax basis in the replacement property on a dollar-for-dollar basis, the taxable capital gain due on the disposition of the replacement property in a fully taxable sale will be larger with an exchange relative to a sale-purchase strategy. The negative effect of the increased capital gain tax liability further reduces the benefit of an exchange. The net present value of an exchange strategy, relative to a fully taxable sale, includes these three disadvantages.
Impact of 1031 Exchange
- Deferred tax and larger investment (+)
- Depreciation is limited (-)
- Recovery Tax increased (-)
- Gaines Tax increased (-)
Tax Deferral Benefits
To quantify the exchange benefit, we first divide the net present value of the exchange strategy by the dollar value of the relinquished property. The Figure to the right presents the tax savings assuming the relinquished property was acquired five years ago. The three curves capture the incremental NPV of the tax savings at the time of the exchange assuming the price of the relinquished property has increased by two, four, and six percent, respectively, since its acquisition five years ago.
One pattern is especially noteworthy: the incremental value of an exchange is positively related to the holding period of the relinquished property. For example, using standard tax assumptions, if the relinquished property was held for 5 years and appreciated by 4% per year and the replacement property is expected to be held for 5 years, the present value of the exchange is equal to 1.06% of the relinquished property’s value. See the table below. If the holding period of the relinquished property was 10 years, the net present value of tax deferral rises to 1.96%. Thus, the attractiveness of the exchange strategy is positively related to the accumulated gain on the relinquished property. Overall, the incremental benefit of tax deferral ranges from 0.4% to 8.5% of relinquished property value, with a mean value of 4.4%, given our assumptions.
|“Relinquished Property”||“Replacement Property”||Benefit as Percent|
of Property 1 Value
|5 Year Hold, 4% Appreciation||5 Year Hold||1.06%|
|10 Year Hold, 4% Appreciation||5 Year Hold||1.96%|
|10 Year Hold, 6% Appreciation||20 Year Hold||5.52%|
Implications of Eliminating the Exchange
Prior to the passage of the TCJA of 2017, the CRE industry predicted that elimination of real estate like-kind exchanges would put downward pressure on CRE prices in the short run, reduce liquidity and transaction activity, and put upward pressure on market rents in the longer run. These concerns reflect the operations of competitive CRE markets: a change in tax law that increases the taxes paid by the typical (marginal) CRE investor in a local market will, in the short-run, reduce the price the investor is willing to pay for a property per dollar of current net operating income, all else equal.
The net tax benefit of 1031 Exchanges to investors (taxpayers) is substantially greater than the loss of Treasury revenue
Our analytical model produces estimates of the tax savings associated with the use of a tax-deferred exchange, relative to a fully-taxable sale, holding constant all other assumptions about the expected cash flow generating ability of the replacement property (e.g., future rents, operating expenses, capital expenditures, mortgage payments, net sale price at reversion). Under certain assumptions, these calculated tax savings can be used as estimates of the maximum short-run price declines or long-run rent increases that would be required in local CRE markets if exchanges were eliminated.
From our model, the average price decline under our base case (no state income tax) assumptions is 4.4%. The maximum price decline across our base case scenarios is 8.6%. When an 8% state income tax rate is included, the average and maximum price declines are 6.1% and 12.3%, respectively. These results bracket the high end of price declines that could occur in the short run in local markets because of the elimination of 1031 exchanges. These percentage price declines can also be interpreted as the percentage increase in the value of after-tax rental income that would be required in the longer run to offset the elimination of like-kind exchanges.
Benefits and Costs
Taxes deferred by investors equals delayed revenue collection by the Treasury. As shown throughout this article, it is important to measure the gains and offsets over the holding period of both properties (relinquished and replacement). Using a “static” (holding everything else constant) model, the Joint Committee on Taxation (JCT) estimates that the cost of exchanges to the Treasury will accumulate to $51.0 billion during 2019 to 2023. We argue that the static present value of the loss in Treasury revenues will be below $20 billion for this period. Our estimate is far lower than the Treasury’s estimate because the JCT estimate only includes the loss in tax revenue associated with the taxpayer’s initial deferral of taxes. It does not consider the increased tax revenues the Treasury will collect in the years after the exchange because of lower depreciation deductions and the increased taxes that will be paid by the taxpayer when the replacement property is disposed of in a fully taxable sale.
It is important that both investors and the Treasury understand the tradeoff between initial deferral and reduced depreciation. The present value of both benefits and offsets determines the overall tax savings/revenue reduction. The Treasury should also consider that the elimination of exchanges would likely lead investors to other tax strategies such as UPREITs and installment sales; this would further reduce the amount of tax revenue collected from the elimination of exchanges. Furthermore, we argue that because of Treasury’s low cost of capital (discount rate), the present value of lost Treasury revenue is less than the present value of exchange tax benefits to taxpayers. This cost of capital “wedge” should be considered in tax policy discussions.
Additional Economic Benefits of Like-Kind Exchanges
We employ data from CoStar and NCREIF (National Council of Real Estate Investment Fiduciaries) to examine the economic benefits of CRE 1031 exchanges. Our empirical analyses demonstrate that like-kind exchanges are associated with higher capital investment in replacement properties, shorter holding periods, and less leverage. More specifically, replacement like-kind exchanges are associated with an investment in subsequent properties that is on average $127,500 (15.4% of value) greater than when a replacement property is purchased following a fully taxable sale. This increased investment is robust over time and by state, although it tends to be larger in strong markets and in states with higher income tax rates. Capital expenditures, specifically building improvements, for replacement exchange properties tend to be higher by about $0.5/sf. The average holding periods for exchanges vs. non exchanges are 10.5 and 11.4 years, respectively. Replacement properties involved in an exchange have mean loan-to-value ratios of 30 percent, while the mean loan-to-value ratio for properties acquired in non-exchange transactions is 43 percent. Using a matched sample of exchange and non-exchange properties to account for selection bias, we obtain similar results.
The opportunity to defer tax on investment gains in real property survived the cuts made in the Tax Cuts and Jobs Act of 2017. The advantage that investors can capture by the use of an exchange is clear in that gains tax can be deferred to a later date. The offsets that come with that decision are a bit more complex. The Treasury should measure both the deferred revenue and the reduced depreciation to estimate the net effect on tax collections. The costs of this program are smaller than originally suggested. On the other side, investors should also measure the benefit and offsets to determine the value in executing an exchange. Typically, the present value of the investor net benefit is greater than the Treasury net loss.