By Paul Banke

If we could use one word to describe the year 2020, I think we would all agree that “unprecedented” would be one that resonates very strongly with the world. The irony in the situation is the use of the word “unprecedented” throughout the media has become unprecedented to say the least.

A word for us in the world of Commercial Real Estate that is more fitting would be “uncertainty.” In today’s climate, the only thing that is certain is uncertainty. The effects of Covid-19 throughout various job sectors reflects two sides of the same coin. For some, Covid-19 has wreaked havoc on business and destroyed the hopes and dreams of small private owners of restaurants, retail stores, and bars. A recent study from Yelp shows 60% of business closures due to the pandemic are now permanent.

With the uncertainty of the Presidential Election mostly out of the way and talks of a vaccine in our near future, there is a glimmer of light at the end of the tunnel as we enter the last month of 2020 which has simultaneously felt like the shortest and longest year ever.

For those of us in the Commercial Real Estate Industry, we are optimistic about the year to come. Industrial and Multifamily have continued to thrive despite the pandemic, but other asset classes such as dine-in restaurants, hospitality, gyms, and office, that rely strongly on the attendance of people, have not fared as well and there is unfortunately strong concern for both short and long-term effects.

There is no doubt that Commercial Real Estate will continue to have a strong rebound but there is one proposal in particular that has many concerned — the elimination of the Section 1031 Exchange. If passed, Joe Biden’s $775 billion proposed tax plan would eliminate the Section 1031 Exchange for investors with annual incomes greater than $400,000.

The history of the 1031 Exchange dates back to 1921 when Congress enacted the like-kind exchange statue for 3 purposes.

1. To avoid unfair taxation of ongoing investments in property
2. To encourage active reinvestment
3. Administrative convenience (The idea of administrative convenience was abandoned by Congress in 1924)

Nearly 100 years later, Section 1031 continues to be relevant as it provides a solution for investors to sell his/her investment property and avoid capital gains. It also encourages transactional activity and stimulates the economy by providing an incentive to reinvest one’s proceeds in the United States and place investors in a more favorable position than before.

Bisnow surveyed 1,042 CRE professionals in November to explore how those in the industry felt about the outcome of the election. In terms of policies that directly effect CRE, Biden’s proposal to eliminate the Section 1031 exchange was the most pressing issue for those in the industry, with 32% selecting it as the one policy that could have the biggest impact on CRE.

Two of the most important studies on the Section 1031 Exchange that show the microeconomic and macroeconomic benefits are the 2015 Ling and Petrova study and the 2015 Ernst & Young Study.

Some key findings from both studies are:

• Like-kind exchanges lead to job creation. Real estate acquired through a like-kind exchange is associated with greater investment and capital expenditures (i.e., job-creating property upgrades and improvements) than real estate acquired without the use of like-kind exchange (Summaries of Ling, Petrova & Barker Studies 5.2016 and 8.2017).

• Like-kind exchanges result in less debt. When the price of the replacement property is close to, or less, than the price of the relinquished property, like-kind exchanges result in a 10 percent reduction in borrowing, or leverage, at the time of the acquisition (Summaries of Ling, Petrova & Barker Studies 5.2016 and 8.2017).

• Property values would drop. In order for a commercial property to generate the same rate of return for the investor (if section 1031 were repealed), prices would have to decline. In local markets and states with moderate levels of taxation, commercial property prices would have to decline 8 to 12 percent to maintain required equity returns for investors expecting to use like kind exchanges when disposing of properties. These price declines would reduce the wealth of a large cross-section of households and slow or stop construction in many local markets (Summaries of Ling, Petrova & Barker Studies 5.2016 and 8.2017).

• Real estate sales activity would decline. Like-kind exchanges increase the liquidity of the real estate market. An analysis of 336,572 properties that were acquired and sold between 1997 and 2014 showed that properties involved in like-kind exchanges had significantly shorter holding periods (Summaries of Ling, Petrova & Barker Studies 5.2016 and 8.2017).

• The total impact on overall U.S. GDP would be a drop of $8.1 billion each year (EY Study 11-23-15).

With a general overhaul of the tax code and a possible elimination of the Section 1031 Exchange in the coming term, now is a good time to investigate how a 1031 Exchange could benefit you.

Paul Banke is an Associate at Kirklen Investment Group and specializes in the acquisition, disposition, and exchange of multi-family investment properties in both Orange and Los Angeles County.

Paul embraces Kirklen Investment Group’s brand of building lifelong relationships with each and every client. With a tireless work ethic and by utilizing his knowledge of the market to ensure he exceeds client expectations and needs, Paul places a huge emphasis on putting client interests first and provides the highest level of service to multi-family owners and investors.