Your storefront, warehouse, or small office building is part of a $2.3 trillion contribution that commercial real estate made to the annual US gross domestic product (GDP) in 2022. And that doesn’t count residential investment or agricultural real estate. 1031 exchanges were involved in 10-20% of these commercial real estate transactions in 2022. Exchanges have a big impact!
Exchanges are more than just part of the real estate market—they contribute to the health of the market, helping create stability, mobility, and growth.
As you know, 1031 exchanges, also known as like-kind exchanges, defer capital gains when an investor or business owner sells property and uses the funds to purchase another investment property. Two studies on the impact of 1031 exchanges on the commercial real estate market and the US economy shed light on Section 1031 of the Internal Revenue Code, which gives 1031 exchanges their power. The studies, including a macroeconomic study conducted by EY and a microeconomic study conducted by academics David C. Ling, PHD, and Milena Petrova, PHD, found that exchanges are more than just a tax benefit for investors–they are good tax policy and a driver of the market.
Exchanges reduce volatility in prices and rents. EY found that without Section 1031, rents would rise by 6% and real estate prices would decline by 6%. This is a significant factor in the ability of an investor to purchase property and keep tenants.
Exchanges are helpful in a distressed market when financing is difficult, as in commercial real estate today, because 1031 exchanges make more capital available in transactions. Properties acquired through an exchange rely less on outside sources of financing than fully taxable transactions and use greater equity, which removes the potential for economic risk.
To maximize the deferral of gain, you must invest equal or greater value and equity into the replacement property. Investors are encouraged to make greater investment in their properties to realize this benefit, improving the quality of property and adding more growth in the real estate market. Buyers have more capital available due to tax savings and leverage and make greater capital investment in their properties, which they do, to the tune of at least 15% more over a fully taxable sale.
Liquidity and Mobility
1031 exchanges help supply and promote liquidity in the market. Property owners sell real estate that they would not otherwise put on the market had they had to pay the tax up front. Section 1031 also encourages the best use of a property, allowing investors to offload properties that no longer fit their portfolio and businesses to move to more appropriate real estate as they scale the business. Section 1031 prevents a “lock-in” effect, where sellers are not willing to sell, and buyers do not have the supply or up-front funds to purchase.
In addition to the initial deferral, exchangers see many other benefits, including the ability to diversify, scale, transition or leverage their investment. Section 1031 has this equally powerful, unsung purpose. It is an important tax policy and is a driver of a healthy real estate market.