Is The 1031 Exchange On The Chopping Block?

I’ve read a good amount on this proposed change and shared a few articles. I do side with keeping the 1031 Exchange in place as is. In my opinion the consequences of eliminating or modifying will stall and hurt not just the real estate industry….but also sales of businesses and other capital assets. And of equal concern, once the door is opened to eliminate or modify one tax deferral program…all other strategies are venerable and at risk…including 401K and IRAs.

What do you think?

From Randyl Drummer’s July 13, 2017 article, of CoStar Group
Conservative lawmakers seeking revenue to offset the cost of cutting tax rates are also taking a hard look at the so-called 1031 exchange, which allows businesses and individuals to defer taxes owed on the sale of investment property if sale proceeds are used to purchase other “like-kind” property as part of an exchange.

In a June letter to the House Ways and Means Committee outlining the industry’s tax reform positions signed by 21 national real estate groups and organizations, including the Roundtable, the groups lobbied hard to keep the 1031 exchange option, citing research analyzing 18 years of transactions that found exchanges result in greater investment and tax revenue while reducing the use of leverage and improving market liquidity.

Ernst & Young also weighed in on the impact of eliminating tax-free exchanges, claiming such a move would subject many small businesses to higher taxes, result in longer asset-hold periods and creating a “lock-in” effect on property values and liquidity. Investors would also be forced to rely more on debt financing at higher capital costs, according to the EY research.

While like-kind exchanges may sound like an unwarranted tax giveaway that doesn’t benefit average people, “that simply isn’t the case,” noted Rep. Steve Stivers, an Ohio Republican member of the House Financial Services Committee. Stivers added that the provision is available to small business and individuals as well as major investors.

“In the vast majority of circumstances, those capital gains taxes will eventually be paid,” Stivers said. “A 1031 exchange simply allows someone to defer the tax while they continue making valuable investments for themselves and the broader economy. What that means is people can choose for themselves to reinvest in their business and community rather than worry about getting sideswiped by a tax bill at the end of the year.”
Want a better alternative to a 1031 Exchange?

$8 billion reasons to save key tax deferment from reform ax

Internal Revenue Code Section 1031 exchanges, more commonly known as “1031s” or “like-kind exchanges,” are a nearly century-old tax deferment mechanism that may be targeted for elimination or curtailment under several tax reform proposals being considered in Congress.

Using a 1031 exchange is simply a matter of timing and taxes: The taxes are delayed in order to make important investments happen in the interim. Specifically, a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property. This may include real estate, heavy equipment, conservation land and other investments.

Importantly, the exchange provides tax deferment — it does not forgive the tax, but rather postpones the tax due until final disposition in order to encourage further investment.

Section 1031 of the code states, “No gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” The intent underlying 1031 exchanges is to provide for continual reinvestment and the resultant growth in the private economy that follows.

For example, when an asset such as medical equipment is sold, federal and state capital gains, combined with recaptured depreciation taxes, might equal more than 40 percent of the sales price. Rather than paying tax on the sale, the seller can choose to defer this by reinvesting the entirety of the sales proceeds via a like-kind exchange. 1031 thus acts as a reliable investment catalyst, one that otherwise would be lost once an investment is sold.

These exchanges help provide an economic stimulus for our nation. Removing that stimulus would cost our nation upwards of $8 billion annually, according to a 2015 study by the accounting firm Ernst & Young LLP (EY) titled, “Economic Impact of Repealing Like-Kind Exchange Rules.” EY also reports that if Section 1031 exchanges are eliminated, investment levels nationwide are expected to decline by $7 billion annually, while national income would fall by $1.4 billion annually.

Importantly, these figures are net of the tax revenue associated with ending like-kind exchange tax deferrals. In other words, with the repeal of Section 1031, the government may get immediate funds but the economy suffers the effect.


The EY study also determined that the elimination of Section 1031’s treatment of qualifying like-kind exchanges would increase the cost of capital, even with lower tax rates. It would also discourage business investment, which would obviously adversely impact the overall economy. Further, eliminating 1031 like-kind exchanges would subject individuals and businesses to a higher tax burden, resulting in longer holding periods, greater reliance on debt financing and less-productive deployment of capital in the economy.

An additional misconception regarding Section 1031 exchanges is that they are tax “loopholes” for the wealthy. The predecessor to Section 1031 was included with the U.S. original tax code because it made sense: It created a deferred process for exchanging (not selling) one valuable property for another without generating a federal tax. Again, taxes are paid once an investment is completed; the money is put to work in the economy and generates economic activity during the delay.

In regard specifically to real estate, a 2015 study by David Ling, Ph.D., a professor at the Warrington College of Business at the University of Florida, and assistant professor of finance Milena Petrova, Ph.D., at Syracuse University, concluded that commercial real estate prices would decline between 8-17 percent in markets with moderate taxes and between 22-27 percent in high-tax states and markets in the event that the tax deferral provided by Section 1031 was reduced or eliminated altogether.

According to the study, moreover, rental prices in these markets would increase significantly, as high as 38 percent in highly-taxed markets.

Section 1031 like-kind exchanges are anything but a tax avoidance loophole; they are a nearly pure form of economic stimulus, a provision of the tax code that acts to increase investment and stimulate economic activity. Even from the tax collector’s perspective, in the final analysis, like-kind exchanges result in loss of depreciation and an increase in local sales and property taxes. There is no apparent downside to redirecting tax revenues in the interim to increased construction activity and the creation of countless jobs.

This country is looking to expand economic activity and generate growth. Section 1031 is a vital part of our tax code that is misunderstood and needs protection. While well-crafted tax reform would be welcomed by our association and our membership, we must not throw out the baby with the bath water.

Section 1031 is a fair and thoughtful means to maintain private sector investment, which results in significant economic stimulus. Tax simplification and lower tax rates are certainly welcome, but this goal can be met without destroying aspects of the code that are actually helpful, fair and valuable, such as Section 1031.

John Harrison is the executive director and CEO of ADISA, the Alternative Direct Investment and Securities Association, the nation’s largest trade association representing the non-traded alternative investment space.


Apartment Slowdown Has Yet to Arrive

“The overall market is being sustained by significant societal shifts that is driving strong, sustained demand,” says Muoio.

IRVINE, CA—Positive demographic trends are keeping wind in the apartment market’s sails even as fundamentals are becoming spotty, Ten-X Commercial said Thursday. Among the areas in which fundamentals are uneven is the supply pipeline, a contributing factor in most of the top five markets in which Ten-X recommends that investors consider selling their apartment properties.

Ten-X Commercial’s latest US Multifamily Outlook report shows that vacancies nationwide rose 10 basis points during the first quarter to 4.3% after remaining flat over the past year. By the time 2017 is over, 330,000 new apartment units will be added to the inventory, and over time that will have a negative impact on vacancies as the absorption rate lags the influx of new supply. The report projects the national vacancy rate increasing to 5% by 2018 before declining demand pushes it to 6.2% by 2020 during a modeled economic downturn.

Rent growth, too, has faltered, with seasonally adjusted effective rents rising just 0.4% during the first quarter, according to Reis data. Annual growth has tapered to just 3%, in contrast to the greater year-over-year increases seen in 2015 and 2016.

Deal volume in the apartment sector reached a three-year quarterly low of just below $27 billion in Q1, although it had improved to $35.2 billion in Q2—still a 1% Y-O-Y decline, according to Real Capital Analytics. Multifamily cap rates remained flat in Q1 at 5.2% after a rise late last year.

With it all, though, demographic trends continue to prop up the multifamily market, Ten-X says. Household formations remained steady at a healthy pace of around 1.6 million in ‘16. A solid labor market continues to fuel absorption, as debt-ridden millennials increasingly delay marriage and homeownership in favor of renting. Ten-X says that as employment and wages continue to rise among younger adults, the 31% of 18- to- 34-year-old still living with their parents should be drawn into the market, giving rise to a key demand source that has yet to be fully tapped.

“The current state of the multifamily sector is a perfect example of the time-honored notion that ‘demographics is destiny,’ ” says Peter Muoio, chief economist with Ten-X. “While softening fundamentals indicate that the sector is poised for a slowdown, that shift has yet to arrive in earnest.”

Even as many large metro areas are increasingly exposed to both cyclical risk and massive oversupply, “the overall market is being sustained by significant societal shifts that is driving strong, sustained demand,” Muoio says. “As long as gainfully employed millennials and other Americans continue to choose renting over homeownership, a majority of multifamily investors can be confident that rents will continue to rise.”

That’s especially true for the five metro areas that Ten-X pinpoints as markets where investors should consider buying multifamily properties: Sacramento, CA; Phoenix; Las Vegas; Raleigh-Durham, NC; and Jacksonville, FL. The favorable demographic trends cited by Ten-X are front and center in these regions, where employment stands at record or near-record levels, and a combination of high demand and light supply pipelines are bolstering rent levels.

Conversely, Ten-X lists five markets in which investors might consider selling. Three are those are in the Bay Area: number two San Francisco, number three San Jose and number five Oakland. Topping the list is New York City, with Washington, DC in fourth place. They’re seeing an onslaught of new supply pushing up vacancies, Ten-X says, while rents may already have reached their peaks, leaving them vulnerable to diminished returns for investors.



Midyear Multifamily Update: Too Much Apartment Construction, or Not Enough?

Even as Single-Family Homebuilding Finally Ramps Up and Cranes Continue to Pop Up for Downtown Apt Projects, US Housing Supply Remains Well Below Longterm Averages

Current supply and demand trends in the U.S. multifamily and single-family markets are sending some confounding signals to investors.

On the one hand, U.S. apartment construction has reached a post-recession peak, driven by demand for high-end luxury properties in the largest CBDs. On the other hand, both multifamily and single-family housing stock remain well below long-term averages that are not nearly enough to house the millions of millennials now entering their 30s and starting families — not to mention the empty nest baby boomers who are increasingly opting for smaller, more conveniently located quarters in downtown apartment rentals.

With new apartment towers being built across almost every large American CBD, it’s easy to forget that nationally multifamily construction inventory remains at roughly half the levels of the 1970s and 1980s.

“There is a lot of building going on, and while no one is saying that we need another luxury apartment building in many of America’s cities, we desperately need more housing,” according to Mark Hickey, real estate consultant for CoStar Portfolio Strategy.

Multifamily construction has been increasing steadily since 2011 and construction levels are now at a rate not seen in 30 years. Yet, due the dramatic decline in single-family construction since the sub-prime mortgage collapse and recession of 2007, new households are forming at greater levels than U.S. housing can support, resulting in a strong supply and demand imbalance.

Home ownership rates are finally increasing again and single-family construction is slowly getting back on track, helping to let some of the steam out of apartment demand. That said, renters continue to lease apartments at a strong clip.

After several rocky quarters for apartment net absorption amid rapidly rising rental rates in many markets, renters filled a net 73,000 units in the U.S. during the second quarter — the strongest quarterly total since 2014 and near an all-time peak — as the national apartment vacancy rate again fell below 6% to 5.9%, according to CoStar data.

“The downtown cranes may give the appearance of a housing supply glut, but in fact, U.S. household formation has outpaced construction by more than 3 million housing units,” said John Affleck, CoStar director of analytics, during the company’s recent Midyear 2017 Multifamily Review and Forecast.

While CoStar is forecasting more temperate levels of rent growth compared with the torrid pace seen during the 2014 to 2016 period, annual rent growth for apartments in 2017 is still expected to exceed last year.

Latest ‘Renters By Choice’: Baby Boomers

While homeownership remains the largest risk for the multifamily sector, and is particularly pronounced among affluent renters who have the means to choose between renting or buying a home, increasingly it’s downsizing baby boomers, not millennials, who are now driving apartment demand growth that sparked the current development wave a few years ago.

“It turns out that the older baby boomers are emerging as the real ‘renters by choice,’ ” Affleck said.”We’ve reached a point in the cycle where the rental rolls have added more 55-64 year olds than age 25 and up.”

Anecdotal evidence from CoStar consultants and analysts supports the rising trend of retiring boomers seeking scaled down quarters, said Michael Cohen, director of advisory services.

“We are being inundated by questions from investors on seniors housing opportunities, which will receive an increasing amount of attention going forward,” Cohen said.

Almost out of necessity as home prices rise, publicly traded and private homebuilders that have based growth and profit projections for the move-up market may finally begin to shift their focus to entry-level housing targeting growing millennial families, Cohen added.

“The demographics suggest that homebuilders will catch on to the fact that the millennial generation, which now averages 26 years old, will produce several million millennial births and will need larger rental dwellings, or be looking for homes,” Cohen added.

“Homeownership remains the goal of most American households and many more households would purchase home if they were more affordable and available,” Affleck added.

The multifamily sector would also stand to benefit from building more affordable apartments as developers have for the most part continued to build expensive luxury buildings in core urban areas.

The expected new supply will continue to weigh heaviest on Class A apartment sector, which is expected to see peak levels of supply for the next two years. However, construction starts have started to slow as labor and equipment shortages push back some projects from their original timelines. Lenders have also pulled back in financing apartment construction in recent quarters, which could further put a brake on new construction.




Multifamily Loan Origination Expected to Hit New Record This Year

Market Performance Will Vary as Construction Levels Peak

By a number of measures, the multifamily sector continues to defy expectations of ‘cooling down’ over the second half of the year and loan origination projections for multifamily property is now projected to grow for the rest of 2017 and into 2018, according to new analysis from Freddie Mac and Kroll Bond Rating Agency analysis of Freddie Mac lending.

While the multifamily market continues to attract investments and capital, market uncertainty in the first part of the year suggested that 2017 full-year volume might taper off. However, a pick-up in second quarter in deals and continued increases in property prices now has Freddie Mac expecting loan origination volume to grow by 3% to 5% in 2017, to between $270 billion and $280 billion, which would be another record year, according to Steve Guggenmos, Freddie Mac Multifamily vice president of research and modeling.

The revised projection comes even as the number of multifamily construction projects is peaking between now and early 2018 and thus moderating overall growth.

That construction activity is pushing up vacancy rates and making absorption of new units take longer in some areas than in prior years, putting some downward pressure on rent growth, especially in certain larger metropolitan areas such as San Francisco, New York City, Washington DC and Miami.

For the U.S. as a whole, apartment rent growth is expected to be similar to 2016 levels, with vacancy rates increasing more slowly than initially forecast, according to Guggenmos.

Still, nearly two-thirds of metros are expected to end the year with vacancy rates below their historical averages. In these areas, demand continues to outpace supply, allowing rents to keep rising.

Guggenmos expects rent growth for the rest of 2017 will continue to be mixed across U.S. metros, moderating the most in areas that previously experienced the highest levels of rent increases, such as Seattle, Tacoma, Sacramento, Nashville, Portland and Atlanta, but still remain above historical averages in those markets.

Meanwhile, San Francisco, New York and Boston are expected to experience a rebound in rent growth by the end of 2017 compared to 2016, while remaining at or below their historical and the national averages, he said

Separately, in analyzing Freddie Mac loan securitizations, Kroll Bond Rating Agency is finding a similar strong performance but with some softening.

The cyclically high levels of construction are impacting Class A properties more than classes B and C, where construction remains fairly muted, the firm said.

This bodes well for the $132.3 billion of multifamily loans that have been securitized since 2010 in 346 Freddie Mac K-Series transactions and CMBS conduit transactions. KBRA’s analysis indicates that nearly 80% of the underlying collateral ($103.9 billion) is class B or class C.

Pullback Continues in the Investment Sales Market for Apartment Properties

Sales of single properties are slowing, suggesting broad correction in the market.

Investors spent a lot less money on apartment properties so far this year compared to 2016, but prices in the sector keep rising anyway.

Prices for mid-rise and high-rise properties inched up 1.0 percent year-over-year, and prices for garden-style apartment properties grew 10.0 percent in the second quarter of 2017, according to the Real Capital Analytics Commercial Property Price Index (RCA CPPI).

Investors still want to buy apartment properties. However, at this point in the cycle, there are not that many assets available for purchase. As buyers go after the assets that are left, they are bidding up the prices for class-B properties and buildings in secondary and tertiary markets.

“We have far more buyers than we have sellers,” says John Sebree, national director in the national multi housing group of brokerage firm Marcus & Millichap.

Volume of deals shrinks

The total dollar value of apartment properties bought and sold in the first half of 2017 was just $62.6 billion. That’s 17.0 percent below the total for the same period in 2016. It’s a steep decline, but still represents an improvement compared to the first quarter of 2017, when the decline was much sharper, according to RCA.

But the second quarter may also be worse than it appears at first. Much of the dollar volume came from a single giant REIT transaction, Starwood Capital Group’s completion of its acquisition of Milestone Apartments for more than $2.8 billion. Sales of single properties are slowing, suggesting broad correction in the market.

Experts have run through several potential explanations for falling sales volumes. Starting after the Presidential election in 2016, investors slowed down their purchases of apartment properties. As the same time, interest rates rose by more than 90 basis points in 20 days. For a while, it made sense to connect the two. But long-term interest rates have sagged since the start of the year. The volume of sold properties has not recovered as a result.

Reversion to historic norms

It now seems that the drop in deal volume may be a correction. “We are reverting back to the mean more than anything else,” says Brian McAuliffe, president of institutional properties for real estate services firm CBRE.

It’s hard to know what a historically normal year is for the apartment sector now. Recent history includes both the boom years before the financial crisis and the years of a slow recovery. In 2015 and 2016 there was another boom in sales of apartment properties.

“We’ve had some really robust years,” says McAuliffe. “Those transactions were facilitated by significant appreciation in property values. There were a lot of gains that investors wanted to realize.” For some experts, it’s no surprise that the dollar volume of apartment deals shrank in 2017. “It was more of a surprise last year that the transaction volume continued to be so high,” McAuliffe says.

Prices keep rising

As investors struggle to find properties to buy, they are willing to bid high for class-B apartment assets. “The spread between the highest quality assets in the market and the market average is narrowing,” says James Costello, senior vice president with RCA.

The cap rates for the top apartments properties and apartments in top markets is already very low (at 2.8 percent for buildings in the New York City boroughs and at 2.2 percent for properties in Los Angeles, for instance), but cap rates for class-B properties continue to fall further. “Part of this narrowing spread is the simple fact that it is harder to push the cap rates for the best of the best assets lower with them at record lows,” says Costello.