1031 exchanges under scrutiny

“Shopping centers have been great 1031 exchange properties, because buyers sell out of other asset-class investments where there are more management issues and the yields aren’t as attractive,” said Kyle Matthews, chairman and CEO of El Segundo, Calif.–based Matthews Retail. “Shopping centers seem to be the perfect blend, where you can get a strong yield, 5 percent to 6 percent, on a good product, or 8 percent to 9 percent on something more risky.”

Almost all the deals Matthews Retail has generated are driven directly or indirectly by 1031 exchanges. Unfortunately, the 1031 exchange has not escaped the notice of government revenue hawks. The term 1031 refers to Section 1031 of the Internal Revenue Code, which permits deferral of capital gains and a recapture tax on an investment property exchanged for a like-kind property rather than sold for cash. And though Section 1031 is popular as a form of real estate investment, several Congressional tax-reform proposals have called for its repeal, and earlier this year the first round of the Obama administration’s budget proposals suggested limits on the exchanges. 

Critics say these incursions derive from an errant view that those who exchange a property and invest in something new will not pay taxes. “That is just not true,” asserted Bill Rose, vice president and national director of the national retail group at Marcus & Millichap. “People are just deferring taxes.”

The 1031 exchange has been the target of politicians several times over the past few years, and this is because it does not apply only to commercial real estate, observes Philip Voorhees, head of CBRE’s national retail investment group in the West. “You can ‘1031 exchange’ various types of like-kind assets — such as aircraft, heavy equipment and computers,” said Voorhees. “Basically, the tax code says if you have a capital asset used for business purposes, you can take that basis, move into another asset and avoid the taxes at the time of exchange and into the future.”

The 1031 has been around since the 1920s. It remains on the books because it creates an incentive for the making of capital investments into physical business assets, which proponents say is good for the economy, Voorhees says. “While some folks think 1031 exchange deals should be prohibited, doing so would likely produce a negative event in terms of economic stimulus,” he said. 

ICSC Office of Global Public Policy and the ICSC Economic Policy Committee have been watching closely as Congress has been discussing initial versions of comprehensive tax reform legislation.  “Eliminating 1031 exchanges is the top concern we hear about from our members related to tax-reform efforts” according to Betsy Laird, ICSC’s senior vice president of global public policy. “We have been working closely with the national real estate organizations to collect data, so we are prepared for this fight.”

Two studies released earlier this year support this contention. According to one, titled “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate,” by Drs. David Ling and Milena Petrova, like-kind exchanges encourage investment. On average, taxpayers using an exchange acquire replacement property that is $305,000 to $422,000 more valuable than the relinquished property. Like-kind exchanges contribute significant federal tax revenue over the long run, the report says, and they also boost tax revenue because of the higher liability. In -addition, like-kind exchanges spur job creation. Greater investment and capital expenditures lead to hiring in such areas as property upgrades and improvements. Then, too, these exchanges result in less debt.

The other study, by Ernst & Young, focuses more on economics and concludes that repeal of 1031 would subject businesses to a greater tax burden on their transactions, resulting in increased reliance on debt financing and less-productive deployment of capital. The cost of capital would increase and thus discourage investment and entrepreneurship. Repeal would slow economic growth, and its overall impact would result in a $26 billion drop in annual GDP.

“When you look at the stated goal of Congress in regard to tax reform, the general theme is to create a more efficient, growth-oriented tax structure,” said Keith Lampi, president and COO of Chicago-based Inland Private Capital Corp. “So reform through repeal of 1031 is an oxymoron — you take that provision away and property owners would hang onto properties longer, it would freeze liquidity in the marketplace and in general have a negative effect on the real estate industry.” As with all commercial real estate, the recession was painful to the 1031 exchange world. Lampi says his company did not begin to see an uptick until the later months of 2012. “2013 was a breakthrough year for us,” he said. “From then on, -transaction volume and liquidity has been very robust.”

Inland’s private-capital group brings 1031 opportunities to investors, buying individual assets and then pooling three or four into one fractionalized ownership-type vehicle. Inland owns 50 to 70 percent of the market for this type of pooled 1031 program, according to Lampi. “Last year we raised just under $450 million in equity,” he said. “Assume about 50 percent leverage, so last year we purchased over $1 billion in real estate on behalf of our 1031 programs.”

With 1031 exchanges in real estate, volume begets volume, Voorhees says. “Through the first quarter, we saw more retail properties get listed for sale than at any time since the last cycle,” he said. “A lot of those deals went into escrow at the end of the first quarter or in the second quarter. Then … they started closing. Our team closed something like 16 deals … [and] nearly 65 percent of those deals were 1031 trades.”

It is no different at other companies. “From 2010 through today, we have seen a 20 percent to 30 percent increase in volume in annual sales,” said Rose. “Given the inventory of listings with our firm, we project a very solid finish for 2015 and going into 2016. The high-water mark for retail real estate sales was in 2007, and about 40 percent of those deals were 1031 exchanges. We already exceeded that by third-quarter 2015.”

One of the reasons for the strength of the 1031 exchange is the aging of the baby boomer investment class, which in the aging process is exchanging out of management-intensive real estate into more-passive investments with stable, bondlike returns — and hence, the popularity of the single-tenant, net-lease retail property. This phenomenon began appearing in the early 2000s, and Rose suggests this has become a dominant trend in the industry. “Let’s say you are a doctor with $8 million sitting in your IRA or other accounts,” said Voorhees. “You are not achieving even 5 percent on that money. You may be achieving a negative return, considering inflation. We see a lot of folks taking some of that retirement money to buy a single-tenant, net-lease property or a small strip center. The investor base is aging, and we are seeing a more conservative investment mode with larger down payments and less leverage.”

Despite the threat from Washington, 1031 exchanges are doing well, and 2015 could end up being a record year for such transactions, especially in retail real estate. “2014 surpassed 2007 as the highest-transaction-volume year for retail properties,” said Voorhees. “By all indications, this year will be better than last year. But if this year is not a record year for 1031s, then 2016 or 2017 could be. The peak transaction-volume years of the last cycle were 2006 and 2007 — and a lot of investors who transacted then put on 10-year financing. As that debt matures, it either triggers a refinance or sale event, and the percentage of deals as 1031s should increase accordingly.”