For almost a century, Section 1031 like-kind exchanges have been instrumental in promoting capital investment in the United States by enabling businesses of all sizes to reinvest their funds into real estate and promote economic activity. This provision is utilized by a diverse range of American taxpayers to expand their businesses, invest for the future, and repurpose real estate for its best use.
President Biden’s proposed restriction of $500,000 on Section 1031 like-kind exchanges would render commercial real estate exchanges, as well as bigger farm and ranch exchanges, ineffective—crucially hitting small businesses.
The COVID-19 pandemic has resulted in a significant proportion of hotel, retail, and office properties throughout the country requiring repurposing. In a post-pandemic economy, especially given the financial sector’s woes as of late, investors are critical to revitalizing and renovating commercial real estate.
Studies conducted on the economic impact of like-kind exchanges have revealed their effectiveness in boosting transactional activity and generating significant employment opportunities. These exchanges are projected to result in the creation of approximately 976,000 jobs, with $48.6 billion in labor income and a total value-added of $97.4 billion to the U.S. economy.
Here’s Why the 1031 Like-Kind Exchange Needs to Stay for Small Businesses
- Like-Kind Exchanges Stimulate Small Business Growth
Small and mid-size business owners and middle-class taxpayers use Section 1031 to transition into facilities and locations that more efficiently meet their needs, instead of being tax-locked into yesterday’s inefficient facilities and processes. In effect, Section 1031 allows taxpayers to shift into the more productive like-kind property, change geographic location, and diversify or consolidate holdings.
Professors David Ling and Milena Petrova conducted a study in 2020 that revealed that Section 1031-like-kind exchanges provide businesses and entrepreneurs with greater motivation and opportunity to invest in real estate and capital. The study also found that buyers who opt for 1031 investments tend to invest much more capital into replacement properties than those who don’t.
- Like-Kind Exchanges Encourage the Evolution and Improvement of Real Estate
The use of like-kind exchanges encourages investment in real estate for all types of companies, leading to improved communities and increased tax revenue.
With the economic downturn caused by the COVID-19 pandemic, many retail and office spaces may become vacant or underutilized as businesses adapt to new operating models. Section 1031 like-kind exchanges can be helpful in repurposing such properties by allowing capital to be directed where it is most needed. This enables buyers to invest fresh capital in transitioning these properties.
According to the Ling & Petrova study, without the tax incentive provided by Section 1031, many transactions would be postponed or abandoned, and the value of real estate would decline. Section 1031 permits businesses to make good economic decisions rather than being hamstrung by negative tax consequences.
- Like-Kind Exchanges Help Support Low-Cash Businesses
If Like-Kind exchanges were eliminated or restricted, it would have a detrimental effect on the economy. It would lead to higher capital costs, slower investment rates, longer asset holding periods, and reduced real estate activity. For cash-strapped companies, it would put greater foreclosure pressure on a company given the increased difficulty of selling their real estate assets due to greater tax liability.
This impact would be particularly severe given the current economic turmoil, which includes inflation, interest rate hikes, market instability, geopolitical risks, and recession. The contractionary effects of reducing or eliminating the 1031 Exchange coupled with the already precarious financial situation of the country would compound the harmful impact on American businesses and the US economy.
Here’s Why the 1031 Exchange Needs to Stay for the Middle-Class
- Like-Kind Exchanges Support Small Farmers and the Environment
Section 1031 is commonly used by farmers and ranchers to make changes to their operations without affecting their cash flow. This provision is also helpful for retiring farmers who can exchange their farm or ranch, which is their most valuable asset, for another property without losing the worth of their life savings.
The exchange of like-kind properties through this provision can also be beneficial for conservation efforts that aim to improve water quality, reduce soil erosion, and maintain wetlands and wildlife habitats. Specifically, these exchanges allow landowners to acquire more productive replacement farms or ranchland in less environmentally fragile regions and adapt their land quickly and cost-effectively to maintain ecological balance in a region.
- Like-Kind Exchanges Help Promote Job Growth
According to recent research by EY, like-kind exchanges have a positive impact on the economy by creating jobs and taxable revenue for various businesses involved in the exchange transaction, such as real estate agents, title and property insurers, escrow/settlement agents, lenders, appraisers, surveyors, attorneys, inspectors, contractors, and building supply vendors. The study estimated that like-kind exchanges result in about 568,000 job opportunities and $27.5 billion of labor income annually.
- Like-Kind Exchanges Defer Taxes for Families to a Time They Can Afford to Pay Them
Many people mistakenly believe that Section 1031 of the tax code eliminates taxes, but this is not true. According to the Ling & Petrova study, most properties gained through a 1031 exchange are eventually sold in a taxable transaction, resulting in the payment of taxes. Repeat exchanges are relatively rare, accounting for less than 20% of all exchanges. Additionally, around one-third of all exchanges involve some payment of tax due to the receipt of the taxable boot—any outstanding loans not repaid and not mirrored in the new contract and any cash value from the old contract that is returned to the client.
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This is for informational purposes only, does not constitute individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.
There are material risks associated with investing in private placements, DST properties and real estate securities including illiquidity, general market conditions, interest rate risks, financing risks, potentially adverse tax consequences, general economic risks, development risks, and potential loss of the entire investment principal.
Past performance and forecasts are not a guarantee of future results.
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