As a current or potential commercial real estate (CRE) investor, you’ve most likely heard the term “1031 like-kind exchange.” Beyond being an excellent vehicle for deferring 100% capital gains taxes, like-kind exchanges, which comprise 10–20% of all commercial real estate transactions (1), have been independently studied and proven to drive the US economy forward.
Learn more about this highly useful tool that helps you, the CRE investor, build wealth while also stimulating the US economy on a micro- and macro-economic level.
The 1031 exchange or a “like-kind exchange” allows you to sell any investment property and reinvest the profits into the purchase of another investment property of equal or higher value.
The 1031 Exchange & Economic Stability
The 1031 exchange has been a tax code since 1921. It is meant to encourage CRE investors to continue to buy and sell properties, and for over 100 years, it has done just that. Like-kind investors invest significantly more capital (15.4%) into replacement properties than non-1031 buyers (1), contributing to local, regional, and national tax revenue, which has far-reaching socioeconomic and financial impacts.
Like-kind investors invest in all types of new and used income-producing properties, such as gross lease, modified gross lease, ground lease, and triple net (NNN) lease, and those that need refurbishing to reach their highest and best use. This capital influx directly helps communities by creating employment and bringing in much-needed resources and tax dollars.
1031 exchange investing also helps essential businesses — dollar stores, c-stores, gas stations, fast-food and QSRs, child care centers, medical clinics, and auto parts stores, to name a few — open new stores in communities that need more resources, update, upgrade, and relocate properties, and promote business growth for the good of the local economy and its people, which then contributes to the health of the national economy.
In any economy, but especially in an inflationary or recessionary economy, like-kind exchanges:
- Stimulate all types of business growth.
- Can increase federal and state tax revenue through reduced deductions and depreciation.
- Keep real property transactions moving, shortening real estate holding periods.
- Reduce the cost of capital.
- Help keep real estate values up and cash-strapped businesses open.
- Minimize large and frequent rent increases.
- Contribute to economic expansion and US GDP.
An Ernst and Young study(2) found “like-kind exchanges supported 976,000 jobs and contributed $48.6 billion in labor income and $97.4 billion of value added to U.S. GDP in 2021.”
The Nitty-Gritty of How the Like-Kind Exchange Puts Money Back into the Economy
The aforementioned economic drivers and benefits of the like-kind exchange can only happen when significant capital is made available in the marketplace. That capital comes from the deferral of tens of thousands to millions of dollars of capital gains per investment. Let’s dig a little deeper into how the money gets put back into the economy.
Depending on your tax situation, like-kind exchanges can produce a federal capital gains tax deferral of 39%. Like-kind exchanges might also allow you to also defer depreciation recapture, an additional savings of up to 25%. That money can only be used to reinvest in one or more investment properties, so it is a direct contribution to the economy.
Let’s look at an example. If you were to sell agricultural land or a shopping center for $50 million with $15 million profit, to use the 1031 exchange tax deferral, you would have to invest all $15 million in other types of income-producing real estate. If you only reinvest $10 million, you will pay capital gains tax on $5 million plus the 25% recapture tax (learn more here). You could potentially lose half that $5 million to taxes, depending on your tax situation. Instead, with the 1031 exchange, that $5 million can buy a high-quality triple net lease property that fulfills a community need and provides stable monthly income to you for 10–20 years.
As you can see, a properly structured like-kind exchange is a win-win for you, the investor, and the economy and its people.
Deferral of Tax Not an Elimination
It’s important to note that this benefit is a tax deferral, not a tax elimination. Eventually, a tax will be paid to the IRS when a 1031 exchange property is sold. The 2020 Ling & Petrova study found “less than 20% of replacement properties are disposed of in a subsequent exchange, at which time the tax is paid, and one-third of all exchanges pay some tax during the year of the exchange because some profit is made and ‘boot’ [a taxable gain] is received.”
Why Some Lawmakers Are Against Like-Kind Exchanges
Many lawmakers and others question why investment properties are eligible for like-kind exchanges with such a generous tax deferral, while other types of investments, such as stocks and bonds, are not. You also hear the opinion that this tax code helps the rich get richer while the nation loses out on tax revenue.
To put these arguments to rest, there is ongoing research and over 100 years of proof that the like-kind exchange encourages economic growth while eliminating it slows economic growth. Additionally, making a similar tax code for stocks and bonds or other investment income would be nearly impossible, as following how that money is reinvested to help the economy in such as direct way would require a massive effort.
Eliminating the Like-Kind Exchange
Eliminating the like-kind exchange would have a direct impact on the US economy in multiple ways.
- Businesses would be forced to hold on to properties that no longer serve their needs, which in turn causes a greater reliance on debt financing.
- Other studies have shown that increasing capital gains taxes means investors end up less willing to pay higher prices for commercial properties.
- If the cost of purchasing a replacement property is well over what an investor would receive from the sale of the original property, this would affect overall market values.
- In cities with lower taxes, market rates could be affected by about 8%; highly taxed states could see up to 17%. Both are likely to disrupt market prices in many commercial real estate markets.
- There could be less incentive to build multi-tenant housing complexes, leading to a housing shortage. This can also inflate rental prices.
- Property owners would cut costs, usually in materials quality, upgrades, updates, and let buildings fall into disrepair.
Thus, as studies show, rather than costing the government money, like-kind exchanges positively affect a variety of industries, keep tax revenue flowing from multiple sources, and contribute to the GDP.
To Wrap it Up — Like-Kind Exchanges Encourage Business and Economic Growth
As you can see, like-kind exchanges promote business and economic growth on many levels. These deals keep real estate transactions fluid, increase market values, keep businesses open and rental prices stable while increasing employment, and contribute to the federal government’s tax revenue, as well as local and regional tax income. Section 1031 has been proven to help sustain America’s economy, especially in tough economic times.
Additionally, the benefits to you as a CRE investor are many. You have the option of selling an underperforming asset and investing your money into a higher-performing property while deferring 100% of the capital gains tax and possibly deferring 25% depreciation recapture, all while building your portfolio with high-quality real estate that provides decades of monthly income. There is no limit to how many times you can use the 1031 exchange, nor are there any limits on value.
Contact Westwood Net Lease Advisors for a 1031 Exchange Conversation
If you have farmland, a mobile home park, apartment complexes, empty shopping centers, or you simply want to let go of underperforming or high-maintenance properties, you can use the 1031 exchange to trade up to reliable, income-producing triple net lease properties that provide stable returns for 10 to 20 years. Not sure where to begin? Westwood Net Lease Advisors is here to help, at no cost to you! We are 1031 specialists who handle every detail of the complex transaction so you don’t have to and we’ll get you to the closing table on time. Contact us today for a no-obligation conversation, 314-997-5227.