Is 1031 all done? An investment tool, commercial real estate boon faces elimination

Recently, on Forest Avenue in Portland, a 12,658-square-foot former Rite Aid sold for $1.5 million.

Three years ago, a $20 million deal that spanned California to Maine, involving four properties, worked its magic for several investors.

Both commercial real estate deals, like many investment property transactions across Maine and the country, were made possible with a 1031, or “like-kind,” real estate exchange. The tax benefit, named after its IRS section code, allows an investor to put off capital gains tax from a sale by investing the money into a similar property.

The tax deferment has made the commercial real estate market hum for decades. That may all change, though with President Joe Biden’s tax plan, which proposes that 1031s be eliminated for investors with incomes higher than $400,000.

“Many in our industry have concerns about the proposed elimination,” says Chris Paszyc, a partner with Boulos Co. in Portland. “Tax deferred exchanges are ubiquitous in the real estate industry here in Maine.”

The exchanges account for 10% to 15% of commercial real estate deals, though it fluctuates depending on the economy and inventory.

Brokers and others in the investment industry say the proposed cap would decrease supply, stagnate prices and have a domino effect on real estate services and real estate and property taxes.

“It would cause a quagmire,” says Matt Pouiliot of Pouliot Real Estate in Augusta. “The 1031 is a primary driver of a lot of the real estate that we deal with.”

‘It’s a good thing’

The 1031 tax exchange was created in 1921, and originally used for types of exchanges where cash wasn’t readily available, says Cheryl Johnson, a tax attorney with Verrill.

“I get a piece of land, you get a piece of land,” and no money changes hands, she says. “Back in the day, people didn’t actually have the cash to pay the tax.”

Over the years, it’s been honed almost solely into a property investment tool.

Biden’s concern is that wealthy investors can defer paying taxes indefinitely. A wide spectrum of those in the investment industry say, however, that like-kind exchanges benefit a broad spectrum of investors and stimulate the economy. A 2015 commercial real estate study found that 88% of replacement properties were ultimately sold through a taxable sale.

Photo / Courtesy of Verrill

Cheryl Johnson, a tax attorney with Verrill, says 1031 exchanges encourage investors to keep investing

“It’s a good thing,” Johnson says. “It encourages people to stay invested.”

Jason Favreau, a principal with BerryDunn in Portland, says if investors don’t have it as an option, it could have an effect on real estate buying and selling decisions.

For example, an investor who sold a $3 million property and had to pay $300,000 in taxes would have less for a down payment on a new property, which would likely result in a smaller loan, leaving $2 million to be reinvested.

“Does the investor want to turn a $3 million investment into a $2 million investment?” Favreau asks. “Property owners want to make decisions about buying and selling real estate based on the investment merits, and tax consequences sometimes influence those decisions.”

He says the 1031 exchange helps facilitate transactions “by allowing the investment itself to drive those decisions.”

The exchange allows a gain on sale to be delayed, Favreau says, emphasizing the word delayed. It preserves historical tax information through the new property, so items like depreciation recapture continue to follow the property owner.

“The 1031 exchange is not designed to provide a free lunch to a seller,” he says.

To list or not to list

Paszyc says common themes he sees with 1031 deals are investors who want to unload a complicated management-intensive property for something easier to manage, or investors who want to buy something bigger. He says that property used in like-kind exchanges tend to be larger, newer and have lower vacancy rates.

“However, we have seen exchanges that have come in all shapes, sizes and quality,” he says.

Some investors, concerned about the possible change, are listing property now to take advantage of the tax code while it exists, Paszyc says.

Consequently, investors may not list if the tax benefit is no longer an option.

“Taxes are often an important consideration for investors looking to sell property,” Favreau says. “Without 1031 tax treatment, investors may continue holding a property instead.”

In recent years, the strong economy has meant a lot of exchanges, or at least the intention — with a 180-day window to make the exchange, investors sometimes can’t close the deal.

Paszyc says the time constraint and limited supply mean “we are seeing many sellers who intended to perform an exchange not able to consummate the ‘up leg’ because a suitable exchange property is not available.”

Johnson agrees.

“Sometimes it’s hard to find a replacement,” she says. That can result in a buyer scrambling to make what could possibly be a bad investment.

“A bad investment is still a bad investment,” Johnson says. “Don’t let taxes drive your decision.”

When a deal can’t be closed, the seller ends up paying the taxes.

The Opportunity Zone factor

Paszyc says some investors may turn to Opportunity Zones more if they can’t use 1031s. He points out they’re a way to defer taxes while also benefiting the greater good by pushing capital into underinvested communities.

The Opportunity Zone tax benefit that emerged from the 2017 tax plan is similar to 1031s in that it allows capital to be reinvested, but with restrictions that include reinvesting into a designated Opportunity Zone and providing jobs and economic gains from the reinvestment within a certain timeframe to eliminate tax payments.

Boulos partnered with Coastal Enterprises Inc. in 2019 to form the CEI-Boulos Opportunity Fund, with a pilot amount of $22 million. It was recognized by Forbes as one of the top 20 Opportunity Zone fund catalysts in the U.S.

The fund, Paszyc says, brings community reinvestment to areas that severely need it, while helping investors defer capital gains taxes.

While the option works for a certain type of investor, it’s not an option for all, though.

“Opportunity Zones offer similar tax benefits, but have very different features,” Favreau says. They’re also “relatively new, more complicated, and limited as to the location of the investment.”

Johnson says many clients using 1031s fall in the $250,000 to $750,000 investment income range, and use the exchange as a key part of their business.

“Once they’ve been using it for a while, it’s not that difficult,” she says. Such investors “are on the lookout, they’re able to work their investments.”

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