New academic analysis illustrates the critical role that tax code’s like-kind exchange rules play for the real estate sector.
The research was authored by David Ling of the University of Florida and Milena Petrova of Syracuse University, with financial support from the Real Estate Like-Kind Exchange Coalition, which is comprised of organizations representing all sectors of the real estate industry, including the National Association of Home Builders.
Like-kind exchange rules allow taxpayers to defer tax when they exchange one property held for investment or business use for other property of a “like kind.” These rules promote savings and investment, allowing capital to flow freely and efficiently—ensuring its best use, encourage commerce and ultimately stimulating economic growth and job creation. The rules, known as a “1031 exchanges,” recognize that exchanging one business or investment property for a similar property does not change a taxpayer’s economic status and therefore should not be taxed immediately. Among other impacts, the rules help support transaction volume in the residential construction space, particularly for multifamily related and land developers.
The study, “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate,” analyzed more than 1.6 million real estate transactions over an 18-year period. Among all commercial real estate transactions, multifamily-related sales recorded the highest use of like-kind exchanges based on both unit and dollar volumes.
The research uses a user cost-of-capital partial equilibrium model that measures financial flows to investors after all expenses are allocated. To simulate a repeal of the tax rule, the model solves for a new property price that holds the investors net present value of the property constant. In the short-run, the model generates a price effect. In the long run, rents adjust to make up for the tax increase.
Among the key findings:
- Like-kind exchanges encourage investment. On average, taxpayers using a like-kind exchange acquire replacement property that is $305K-$422K more valuable than the relinquished property, while replacement properties without using an exchange are cheaper or of equal value.
- Like-kind exchanges contribute significant federal tax revenue. In 34 percent of exchanges, some federal tax is paid in the year of the exchange. More importantly, over the long run, like-kind exchanges boost tax revenue because of the higher tax liability that arises in the years following the initial exchange.
- 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.
- 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.
An important conclusion of the analysis found that in 88% of cases, taxpayers using like-kind exchanges did not defer paying tax indefinitely, as some critics charge, but paid substantially more in tax (19%) when the property was sold than would have been due had the exchange not occurred.
The report found that if the tax code’s like-kind exchange rules were repealed:
- Taxes would increase for thousands of multifamily and commercial property owners. For a typical property owner who defers his or her gain, repealing like-kind exchanges would raise the effective tax rate on the taxpayer’s investment (including rental income and gain; nine-year holding period) from 23 percent to 30 percent.
- Property values would drop. In order for a 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, 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.
- Rents would increase. Over time, real rents would need to increase from 8 to 13 percent before new construction would be economically viable. These higher rents would reduce the affordability of multifamily and commercial space. The price declines and rent effects of eliminating real estate like-kind exchanges would be more pronounced in high-tax states.
- 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.
The study highlights the importance of the like-kind exchange rules for the real estate sector, as well as the construction of new residential and commercial properties. While the research did not examine the land development sector, this industry also benefits from the existing rules.
By way of conclusion, the authors note with respect to the findings identified above:
“These micro effects are likely to have macro-economic consequences as well. For example, decreased construction and investment activity in commercial real estate markets will depress employment in sectors and markets where like-kind exchanges are commonly used.”