Photo of Todd R. Pajonas Todd R. Pajonas

MELVILLE, NY—You might think that the current efforts to repeal or reform the Affordable Care Act have nothing to do with real estate investing. However, health care reform is the last bridge that Congress needs to cross before they can turn their attention to comprehensive tax reform.  Once Congress moves on to tax reform, there is the potential danger that IRC section 1031 tax deferred exchanges could be eliminated to pay for tax cuts and that could prove devastating to the real estate market. An IRC §1031 tax deferred exchange allows real estate investors to defer the capital gains tax they would normally recognize upon the sale of their business or investment property so long as they purchase real estate for an equal or greater value.

What we know as the modern era of 1031 exchanges started with the Tax Reform Act of 1986. However, exchanges of property, in one form or another, have been allowed since 1921—almost 100 years. Current efforts to repeal IRC §1031 began with the 2010 Volcker Report which advocated its elimination. In the intervening years both Democrats and Republicans found at least one area of common ground, with some members of each party calling for its elimination.  President Obama floated a more business friendly plan in 2015 seeking to limit the capital gains tax deferral to $1 million instead of an outright repeal. More recently, in order to pass a “revenue neutral” tax plan, President Trump and the Republicans have explored the elimination of 1031 exchanges in order to “pay for” other tax cuts.

Glen Kunofsky, who is the top single-tenant net lease professional at Marcus & Millichap, and handles many 1031 transactions, said, “1031 has been an essential tool for real estate investors to go from management intensive ownership to non-management intensive real estate assets like net leased properties.  Eliminating 1031 would be a major shift for real estate investors and would have a substantial impact on the market, values could be significantly impacted, and investors might opt to hold on to their existing property. There could also be a meaningful impact to the users of this real estate tool if developers are unable to capitalize upon a clear exit strategy, which the 1031 market currently provides.”

Regardless of what politicians and pundits say, health care reform, or at the very least a repeal of the ACA, needs to be completed before Congress can move on to comprehensive tax reform, and that is what makes the battle for health care reform so important to real estate investors.  The “cost” of health care reform, including whether the Affordable Care Act 3.8% capital gains tax surcharge will survive or be repealed, needs to be known in order for tax reform to proceed.  With the traditional August recess looming some in Congress, as well as President Trump, are calling for the Affordable Care Act to be repealed or defunded in order to force new health care legislation at a later date.

With crucial votes on the budget and debt ceiling looming will there be enough time to tackle tax reform before the year ends? True tax reform, as opposed to changing tax brackets, personal and corporate tax rates, and the standard deduction, will be very difficult to accomplish before the end of the year, and even more so next year with the mid-term elections. Congress typically doesn’t attempt to pass difficult legislation during an election year because it carries the risk of alienating voters. The elimination of 1031 exchanges would most likely only occur with true tax reform, where portions of the code are rewritten or eliminated, as opposed to making smaller changes and keeping the existing framework in place.

Joseph French, Jr. a broker with Marcus & Millichap’s Institutional Property Advisors division, said of the potential for the repeal of 1031 exchanges, “I foresee the elimination of the 1031 exchange as a major disruption of the real estate market. We have seen that the finance world does not like changes. Without debt the real estate market comes to a halt. For example, in 2008 residential loans became problematic and the next thing we knew there was very little commercial loans available. At the time, the default rate for commercial loans was around 5%. The lack of liquidity exacerbated the problem and we had very few transactions.”

If 1031 exchanges were eliminated it might not necessarily be the end of the world for real estate investors if it were replaced by something similar such as “full expensing.”  Full expensing is comparable to accelerated depreciation whereby capital purchases are immediately expensed, instead of depreciated over a period of time.  While not an accurate comparison there are some similarities between full expensing and a roll-over. However, there are limitations as full expensing does not take into account the value of land, would only work if the sale and purchase were in the same tax year, and would require investors to always trade up in order to offset their gain.  It is not a perfect solution to replace 1031 exchanges but it would leave most real estate investors with a different tool to defer their capital gains tax.

Despite Congress looking to repeal 1031 exchanges as a means to obtain additional tax revenue, many economists believe its repeal would actually wind up costing the government tax revenue.  A 2015 analysis by Ernst & Young found that either a repeal or limitation of 1031 exchanges could lead to a decline in GDP of about $8 billion annually.  It would not only constrict the real estate market but also cause a loss of income for real estate professionals, such as brokers, attorneys, accountants, appraisers, insurers, lenders, contractors and manufacturers. This would translate into less taxes paid on ordinary income for their services, as well as the loss of sales tax for the items they don’t purchase because of their diminished income.  Additionally, state and local governments would collect far less in transfer tax as there would be fewer real estate transactions.

Joseph French added to these thoughts by stating, “No way are they going to get the additional tax revenue that they predicted as the people I speak to will just not transact.”

President Trump has had difficulty moving forward with his legislative agenda because his short time in office has been inherently volatile.  There are many reasons for this volatility but some of the reasons include the Russia election hacking investigation, FBI Director James Comey’s firing, White House leaks, conservative Republicans, lack of middle ground between Republicans and Democrats, Tweets, North Korea, terrorism, the House Majority Whip Steve Scalise shooting, and the continually rotating roster of Trump advisors and officials. All of these issues stand in the way of President Trump and Congress focusing on their legislative agenda and makes it hard to accomplish health care and tax reform.

It is a sad reality that we can take some comfort in the relative dysfunction of the government to protect us from a potentially disastrous piece of legislation.  When you consider that exchanging has been in the tax code nearly from its inception the impact of the repeal of this cornerstone becomes even greater.  “With the investment sales market already slowing down this past year, doing away with the 1031 exchanges would be a devastating blow to the market,” added John Krueger, Regional Manager of Marcus & Millichap’s Manhattan and Westchester offices.  “Having the option of doing a 1031 exchange has been an important factor for how we advise our clients.”

Should Congress shift directions and move onto tax reform, instead of continuing its efforts to first repeal or reform the Affordable Care Act, they would need to pass new tax legislation without knowing the true cost of health care reform.  Can Congress assume that the 3.8% health care surcharge will remain or will they account for the loss of revenue by assuming ACA is eventually repealed?  A scenario where Congress tackles tax issues before the end of the year, in order to notch a legislative victory, is one in which 1031 exchanges more likely survives.  We would most likely see changes within the existing tax framework, instead of true tax reform, and that would save 1031 exchanges.

Although there is much that stands in the way of true tax reform, which would pave the way for the potential elimination of 1031 exchanges, the threat remains.  Governments many times do what is politically expedient regardless of long term consequences.  A prominent example of this mindset is the failure of health care exchanges, and resultant increases in premiums, which clearly illustrate that the Affordable Care Act had large flaws which were not remedied before its passage.

The rush to reform or repeal the Affordable Care Act carries with it the threat of again passing a heavily flawed piece of legislation instead of taking the time to establish a lasting framework.  1031 exchanges could still be repealed to pay for other tax cuts but the hope is that gridlock will prevent the politicians from making a big mistake.

Todd R. Pajonas is president of Legal 1031 Exchange Services, Inc. He may be contacted at todd@legal1031.com. The views expressed here are the author’s own.