1031 Exchange, a Cherished Real Estate Tax Break, Faces Extinction

A much-loved tax advantage in the commercial real-estate industry is on the chopping block even as chances dim for the passage of a broad federal tax overhaul this year.

Why? If a sweeping bill doesn't get traction in Congress, there is still a decent chance a narrower tax rate cut will get passed, according to lobbyists and Capitol Hill officials working on tax legislation.

To finance such a rate cut, some in Congress have in their sights what's known as the 1031 exchange provision, which enables sellers of real estate and other assets to defer capital-gains taxes by reinvesting the proceeds in "like-kind" properties.

Say an investor sells an apartment building for a $10 million profit. If he or she reinvests the proceeds in a strip mall or another commercial property, the investor doesn't have to pay taxes on that capital gain at that time.

The 1031 exchange could effectively have ended as part of the tax-overhaul plan proposed last year by House Republicans, which gained traction after Donald Trump was elected President. But that plan -- named "Better Way" -- would have included other provisions that would have made it more palatable for the real-estate industry.

Now real estate lobbyists say the Better Way plan is getting bogged down and it is looking like the real-estate industry might have to take the medicine without the spoon of sugar to help it go down even though they would benefit from the lower rates.

As the Better Way plan "has lost a bit of luster of late, the odds have increased that like-kind exchanges are eliminated with no offsetting provision," said Green Street Advisors in a recent report.

The benefit is vulnerable because many Democrats and some Republicans consider the provision a loophole with limited broader economic benefit that could be sacrificed to pay for lower tax rates. "It's really become just a way to defer tax liability," said Mark Mazur, who was the Obama administration's top Treasury tax official and is now director of the Tax Policy Center, a project of the Urban Institute and Brookings Institution.

But real estate executives say getting rid of 1031 exchanges would be devastating for the economy as well as their industry. Like-kind exchanges are used in 10% to 20% of commercial real-estate transactions, according to Green Street.

They also have sparked the creation of a cottage industry of firms that pool 1031 exchange investments for smaller investors. If the provision is eliminated, "it would cause a lot of transactions not to occur," said Jeffrey DeBoer, chief executive of the Real Estate Roundtable.

The economic impact would ripple throughout the economy because investors who acquire real estate through 1031 exchanges are more likely to invest in those properties than those that pay cash. In such trades, they typically don't have to reach into their pockets, Mr. DeBoer explained.

"Therefore you have capital you can now put into the newly acquired property," he said.

The House Ways and Means Committee hasn't yet released a bill and there is disagreement among Republicans about where they are heading. Lawmakers have had "good discussions" on like-kind exchanges but haven't "come to closure" yet with a decision, said Rep. Pat Tiberi (R., Ohio), a senior committee member, in an interview last week.

The 1031 provision of federal tax law applies to a wide range of assets -- including cars, planes and patent rights. Real estate accounts for 36% of the exchanges, according to Ernst & Young LLP. In 2014, the Joint Committee on Taxation estimated that repealing like-kind exchanges would raise $40.6 billion in additional tax revenue over one decade.

Adopted in 1921, the 1031 provision originally was used primarily in the real-estate world by neighboring farmers who would exchange one parcel of land for another for such purposes as straightening out property lines, according to Louis Rogers, chief executive of Capital Square 1031 LLC, a Richmond, Va.-based firm that sponsors over $100 million worth of 1031 exchange deals annually. Over the decades, the use of the provision broadened widely thanks to "extremely supportive" rulings by the Treasury Department and Internal Revenue Service, he said.

Exchange firms such as Capital Square 1031, Inland Private Capital Corp. and Passco Cos. purchase billions of dollars worth of real estate annually. Capital Square's deals include a Tampa, Fla., apartment complex and a medical office building in Birmingham, Ala.

Proposals to eliminate or change 1031 have come up before in Washington, D.C. But the current threat is the most serious, especially if Republicans get behind it, real-estate industry executives said.

"Republicans have control of Congress and the White House," Mr. Rogers said. "They should be able to run the table and cram this down our throats."

Most observers believe the Better Way plan could have ended the 1031 benefit, even though it didn't specifically address it. Still, if that had happened, Better Way would have lessened the impact partly by allowing buyers of real estate to treat the entire cost -- excluding land -- as a business expense that could be used to reduce income instead of depreciating those costs over time. This would be good for real estate owners but not enough to offset the pain of losing 1031 exchanges, industry executives say.

A slimmed-down tax rate cut could be even more of a nightmare for the industry, if it wiped out the 1031 provision without the change in business expenses, officials said. The changes being considered "could be extremely detrimental or just quite harmful," Mr. DeBoer said.

Write to Peter Grant at peter.grant@wsj.com and Richard Rubin at richard.rubin@wsj.com

(END) Dow Jones Newswires

June 13, 2017 07:14 ET (11:14 GMT)