Are 1031 exchanges at risk if Congress closes the tax loophole?

As we have now surpassed Labor Day in the election year of the pandemic 2020, expect political rhetoric to reach a fever pitch. Sorry. Pun intended.

As our nation slowly recovers from business lockdowns, distance learning, storms along the Gulf Coast, wildfires in California and upheaval in our streets – all while the government responds monetarily to stem the bleeding – expect the next question to be – “how on earth can we possibly pay for all of this?”

California has proposed a 16.8% marginal tax through Assembly Bill 1253 aimed at those who earn more than $5 million annually. Who cares, you may ask? They should pay their fair share. What’s another 3.5% of their income to help the greater good?

Consider this. Many small business owners could tip this scale and face the extra burden. How long will they remain in California when Nevada, Texas, and Washington have ZERO state income tax? If we export a significant amount of our tax base – who’ll be left to foot the tab?

Proposition 15 — on the California ballot in November — proposes to split the property tax roll and tax commercial properties differently than residential parcels. I’ve written ad nauseam about where the ultimate bill will be paid. Yep! By you as the consumer of goods and services.

You see, if the cost of commercial real estate rents rises through an increase in property taxes, businesses who occupy the industrial buildings, office space, and retail storefronts will be forced to pass that expense along to their customers — you.

A target for a significant tax grab could also be the way in which capital gains taxes are deferred through 1031 exchanges. I’ve not seen any storms massing on the eastern horizon – but it’s always calmest – so the saying goes.

Congress could propose eliminating this “loophole” and generate billions in tax revenue. It currently works like this: If you sell a piece of income property, you are allowed to defer your long-term capital gains taxes. Simply, the seller enters a contract, creates a qualified intermediary before closing, closes, net sale proceeds go into an accommodator account, the seller identifies an upleg purchase within 45 days from close, and buys the upleg at the earlier of 180 days from close or the filing date of next year’s tax returns. Easy!

Literally thousands of these are done each year. Deferred are federal long-term capital gains of 15-20%, depreciation recapture of 25%, California state taxes on capital hains of $13.3%, and 3.8% for the Affordable Care Act. A whopping amount! Assumed is – if we tax those sales today vs. allowing a deferral – think of the revenue we’d generate!

Good in theory – but here’s the rub.

Commercial property owners often ask me this question when I visit: If I sell, what will I do with the proceeds? After all, I don’t want to pay close to half my gain in taxes! We then have an in-depth conversation about tax-deferred exchanges. So, if Congress were to change the rules or disallow 1031 exchanges altogether, sellers would be left with very little motivation to sell.

Some might say this argument is quite self-serving. After all, this guy is paid to sell commercial real estate. True enough. However, please don’t forget the multitude of industries that benefit from the sale and purchase of commercial real estate. Title companies, escrow holders, transactional lawyers, CPAs, qualified intermediaries, lenders, property inspectors, environmental engineers, contractors all drink from the trough of a commercial real estate transaction. Behind the scenes are real people – with families – whose livelihoods depend on property sales.

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104.