Using tax law to create new housing opportunities is outside-the-box thinking
Like-kind property transactions can be a “win-win-win” for all involved
Driving around your community you are probably starting to see more and more commercial properties that are vacant.
Some were stores that recently vacated. Some have been sitting dormant with a “For Lease” sign on the property for a year or two.
And then there are those that have been vacant for so long that they no longer even advertise that the property is available.
It’s easy to lament the loss of these businesses in a community, and to be frustrated by the blight that empty storefronts could portend.
But what isn’t so easy is seeing these forgotten spaces and imagining them as something new and vibrant.
Given the current economic circumstances – a burgeoning housing crisis in America with most major markets really feeling the pain of a lack of both availability and affordability – as well as a commercial real estate sector that is on the ropes due to the pandemic, some are utilizing a venerable income tax tool to spur the economy, develop more housing for those who need it, while also creating jobs, adding to the tax base, and attracting new businesses to livable communities.
Enter 1031 Like-Kind Exchanges.
Section 1031 of the Internal Revenue Code allows a real estate property, used for business or held as an investment, to be exchanged for another property that is of “like-kind.” The IRS notes that “properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. All real property is generally of like-kind, regardless of whether it’s improved or unimproved. For example, an apartment building would generally be like-kind to farmland and a warehouse is of like-kind to a medical arts building. However, real property in the United States is not like-kind to real property outside the United States.”
Sounds confusing, right?
Evan Liddiard, CPA, director of federal tax policy for NAR, can put that in layman’s terms.
“Let’s suppose that you were left some raw land by a relative who passed away a long time ago when it was worth $100,000 and now it’s worth $250,000,” Liddiard said. “You have a big, unrealized gain there. So, if you were going to sell the land, you would have to pay a lot of tax on that gain. And this could well discourage you from considering selling.
“But, if you decide that instead of keeping the land, you wanted to trade it for residential housing that is worth the same amount of money, then you can make that exchange and defer the tax until the new property is sold later.”
Liddiard explained that the rationale for this tax treatment is that you’ve only changed the form of your investment, not the substance of it – you are still invested in real estate.
Now put two and two together….
Instead of purchasing existing residential units, imagine now combining the trends in commercial and residential real estate and approaching the owner of one of those long-vacant commercial properties talked about earlier. Rather than selling your land outright, you instead swap it for the commercial property using the 1031 like-kind exchange. But instead of keeping it commercial, you use the money you defer in taxes from the sale of the land to convert the commercial property to mixed-use, or even residential.
While doing that would require a significant investment, it would also create value as well as new construction jobs as the property is transformed and ultimately would result in the production of new homes, which could be purchased or rented by individuals looking for available or affordable housing.
“It can be a win-win-win, for the housing sector, for commercial, and for the economy” Liddiard said. “Many cities – take Washington, D.C. for example – have a lot of mixed-use development already with condominiums or apartments above stores on the ground level. So, in places like that, it should be an easy conversion from commercial zoning to mixed-use. But in other places, if you are talking about an area that is industrial, you may have to sell the idea to local leaders by helping them see the benefit to the community.”
Nevertheless, some of this is happening already – places like shopping malls are being reimagined with a combination of commercial and residential units combined in the same space.
Leveraging the 1031 like-kind exchange to energize this concept even more is pretty common and has few, if any, stumbling blocks.
NAR released a survey of its members recently that looked at 1031 property transactions between 2016 and 2019 and used the data to view the economic impact they have.
In the span of the study, 61 percent of NAR members reported being involved in at least one like-kind transaction, and a majority of the properties that were transferred using a like-kind exchange were held by small business investors who used additional capital to invest in the property further – about 90 percent of the time.
Apart from the tax deferral, the primary reason clients engaged in a 1031 exchange was to use the equity from the exchanged property to acquire another property, for estate planning, to diversify a portfolio, or using the equity to complete a development project.
But not everyone is a fan of like-kind exchanges. There are critics who think they should be repealed because they are unwarranted tax “loopholes” that do little but enrich investors. However, many critics do not understand how 1031 operates and they equate tax deferral with tax-free treatment, which is simply not the case.
Section 1031 has survived in the tax code since 1921 because policy makers understand that it removes barriers to greater investment and provides flexibility for investors to channel underutilized capital resources into higher and better uses.
During the debate over the 2017 Tax Cuts and Jobs Act, some in Congress wanted to scrap Section 1031 altogether. Due to strong education efforts of Members of Congress by NAR and other commercial real estate allies, Congress retained like-kind exchanges for real estate, acknowledging its importance to the economy.
A recently updated study by two prominent university professors found that eliminating like-kind exchanges would likely lead to a decrease in transaction activity in most commercial real estate markets as well as price declines in some markets. The also concluded that repeal would likely produce a decrease in capital investment, an increase in holding periods and that the expected revenue to the U.S. Treasury from repeal is likely overstated.
Instead of regressive action, using what has existed in the tax code for almost a century to help boost housing availability and affordability is the kind of outside-the-box thinking that could help both the housing and the commercial real estate markets and, in turn, assist the economy in its efforts to rebound from the devastating effects of a global pandemic.