Ending 1031 exchanges: Would Biden’s plan hurt smaller owners more than Trump and peers?
How the industry is responding to the proposed tax change that could impact as much as 20 percent of commercial real estate deals in the U.S.
Presidential candidate Joe Biden’s proposal to axe like-kind exchanges for real estate — part of his plan to offer more federal aid to children, senior citizens and people with disabilities — makes veteran investment sales broker Bob Knakal think of New Years Eve in 2012.
Knakal was racing against the clock to close 23 deals with buyers who all wanted to defer taxes by rolling their capital gains on recent sales into new properties using the federal tax code’s 1031 provision.
The flurry of activity was due to Obamacare’s 3.8 percent Medicare tax on capital gains that went into effect the following day, and the threat that Congress might soon pike 1031 exchanges as well. Knakal said the fear fueled so many eleventh-hour deals that his brokerage at the time, New York-based Massey Knakal (which was acquired by Cushman & Wakefield two years later), made 60 percent of its revenue during 2012’s fourth quarter.
“I think the same thing could happen this year,” said Knakal, who now co-chairs New York investment sales at JLL.
Biden’s proposal, which he announced during a campaign speech in New Castle, Delaware, could have big impacts for property owners large and small. Like-kind exchanges are estimated to account for as much as 20 percent of all commercial real estate deals around the country, a market that was valued at $560 billion in a 2019 analysis by Real Capital Analytics of property sales of $2.5 million or higher.
Biden says eliminating 1031 exchanges for well-heeled real estate investors, as well as stepping up tax enforcement for the wealthy, will amount to $775 billion over a decade. Congress’ Joint Committee on Taxation projected that between 2019 and 2023 real estate investors will defer $51 billion in capital gains using like-kind exchanges, as cited by Bloomberg.
Like-kind exchanges have been on the chopping block plenty of times before, so some are dismissing Biden’s proposal as an empty threat. But the Democratic candidate may be able to count on a fresh surge of partisan support considering President Donald Trump’s penchant for using 1031 exchanges in his real estate business.
Knakal is of the latter mindset. Though he wouldn’t provide further details, the broker claimed to have four properties on the market now where the sellers have told him they want to offload their properties by year-end due to Biden’s proposal. “People are definitely giving it credibility and it’s impacted the decision-making for some,” he said.
Camille Renshaw, co-founder and CEO of New York-based commercial brokerage B+E, which specializes in 1031 exchanges involving net-lease properties, said the phones in her office have been blowing up since Biden’s announcement. She argued that the property owners who would be left most exposed if the tax provision were eliminated are far less wealthy than Trump and his well-heeled peers.
“Most of these people aren’t Trump,” she said. “It’s usually working class people who made a big pop of money through real estate in their life.
In the grand scheme?
For many, however, Biden’s proposal to kill the tax provision — once and for all — is the least of their problems.
“I struggle to think that a real change in 1031 is in the cards,” said Rick Jones, partner and co-chair of Dechert’s global finance and real estate. “It’s like about worrying about a zit on the end of your nose when you’re about to get hit by a tsunami.”
Exhibit A: a global pandemic and economic fallout with no end in sight. That’s followed closely by the potential meltdown of commercial debt markets, among many other factors.
Though Biden’s proposal seems like a no-brainer for Democrats, trade organizations and some economists agree that the 1031 provision stimulates transactions, which in turn generate tax revenue for local government, and jobs for intermediaries on each deal. And there’s evidence that eliminating 1031 slows market activity.
Like-kind exchanges were banned for assets including artwork under the Trump administration’s 2017 Jobs Act, and art dealers say the tax change led to a subsequent slump in discretionary sales of high-priced works.
But fears that a similar thing could occur in commercial real estate is tempered because, as many, including Jones and Knakal, point out, this is far from the first time 1031 has been on the chopping block, and it’s always escaped unscathed.
In 2017, as President Trump began cutting away pieces of the tax code, like-kind exchanges appeared to be headed for the history books. But real estate investors were spared and the exchange disappeared for all assets except property, leading to speculation that the reprieve was due to Trump’s own use of 1031 in his investments.
The Trump Organization used a like-kind exchange in 2005 to defer capital gains tax on $1 billion in profits earned through the sale of a development site on Manhattan’s Upper West Side. The funds were redirected into the purchase of two office buildings, at 1290 Sixth Avenue in Manhattan and 555 California Street in San Francisco, under the 1031 provision.
Bloomberg reported in June that the Trump Organization is considering selling its stake in both assets — which would mean the company may either be teeing up another exchange or preparing to face a significant tax bill.
James Nelson, head of Tri-State investment sales at Avison Young, said half of the firm’s deals had one party using the transaction as part of a like-kind exchange.
Many in the industry, however, push back on the idea that 1031 exchanges are a mechanism for wealthy real estate investors and institutions to skip out on taxes. Some like Starwood Property Trust’s Barry Sternlicht don’t like property taxes, but eschew like-kind exchanges. During his firm’s second quarter earnings call, a few weeks after Biden’s proposal came out, Sternlicht said he has never used the 1031 provision, which he referred to as lifetime exchanges, and that the tax code “should go away.”
“It isn’t required and it isn’t helpful to real estate,” the Starwood chairman and CEO said.
Renshaw — who maintains that mom-and-pop real estate owners would take the biggest hit — called a like-kind exchange of more than $10 million unusual. Most 1031 transactions her brokerage handles range between $3 million and $4 million, she said. Deals that use the tax code provision to gain capital gains account for half of B+E’s business.
It’s like about worrying about a zit on the end of your nose when you’re about to get hit by a tsunami. — Rick Jones, Dechert
She pointed to a deal she’s working on now with a 70-year-old retiree living in Brooklyn. The man is selling the small mixed-use building where he ran his plumbing business and rented out three apartments, and plans on rolling the gains into two net-lease properties, likely with a bank and a fast-food restaurant as tenants. Her client plans to hold onto the property for 15 to 20 years and then leave it to his grandchildren, she noted.
Less established real estate owners are “trying to protect wealth for the next generation,” Renshaw said.
Death and taxes…
In the case of the ultra-rich, however, that’s exactly what lawmakers are trying to avoid.
When a 1031 investor dies, all deferred capital gains taxes owed are wiped out, with beneficiaries responsible for just an estate tax. Biden’s proposal would address that concern among smaller investors by allowing like-kind exchanges to continue for those making under $400,000 a year.
Economist Sam Chandan, dean of NYU’s Schack Institute of Real Estate, argued that regardless of the merits of Biden’s proposal — which the presidential candidate says will go toward universal childcare and in-home care for seniors — 2020 is not the time.
Removing like-kind exchanges would have a downward effect on pricing that he argued could compromise banks and lenders.
“Roughly 50 percent of banks’ exposure in the United States is real estate or construction loans,” said Chandan. “To further downward pressure on asset values at this point in time could have potentially significant spillovers into the health and stability of some banks, which would be highly undesirable. We need credit to flow.”
Jeffrey DeBoer, head of the Real Estate Roundtable in Washington, D.C, said the national trade group would support a Congressional review, but stressed the importance of like-kind exchanges “during economic downturns when access to capital is less certain.”
James Whelan, president of the Real Estate Board of New York, echoed that. “It falls in the category of … if it ain’t broke, don’t fix it,” he said.
Dechert’s Jones attributed his blasé outlook on Biden’s proposal to the fact that many Democrats use like-kind exchanges for their own personal wealth, noting that “lots of big dollar D’s do 1031s.”
“Mr. Obama didn’t get rid of it and he controlled both houses at one point,” Jones said. “As Michael Jordan said when asked why he was not more political: ‘Republicans buy sneakers too.’”