The proposal to curb Section 1031 of the U.S. tax code is receiving a lot of attention from commercial real estate investors. Commonly known as 1031 exchanges or like-kind exchanges, Section 1031 trades account for up to 20 percent of all commercial real estate transactions, according to a recent study by experts at the University of Florida and Syracuse University. In just the net lease sector, we have estimated that somewhere between 55 and 70 percent of transactions each year could be 1031 exchanges.
Large and small investors alike rely on the 100-year-old provision which provides property investors with a tax deferral on the gain from a sale contingent upon the satisfaction of a number of conditions – the primary one being that the sale proceeds are used to purchase a like-kind investment within 180 days. Proposed legislation, however, could severely limit the current policy by allowing only gains of up to $500,000 for individuals and $1.0 million for joint filers to be eligible for deferral in any single tax year. This proposed limitation could have a material impact on commercial real estate transactions if adopted, but we encourage investors to evaluate future strategies based on their particular goals and situations, as real estate investments will continue to provide investors with benefits that go well beyond Section 1031 considerations. Here are a few benefits that investors should keep in mind amid the uncertainty of future tax policy:
Predictable Cash Flow | Investment properties can generate steady monthly income. In turn, that provides owners with significant financial flexibility. Depending on their strategy or situation, investors may live off the cash flow, use it to pay down debt, invest in other assets or save it.
Appreciation | Real estate often increases in value over time and can provide a substantial payout upon a sale or refinancing, particularly if an owner improves a property and increases its net operating income. Appreciation also strengthens equity in properties, which in turn enhances the net worth of owners.
Residual Value | In some cases, a property’s value may fall over time. A long-term lease may expire, for example, or a tenant may go out of business. Still, unlike stocks, which can lose 100 percent of their worth, the building and underlying land does retain some value.
Diversification | Investment properties can play a critical role in portfolios geared toward maximizing returns and minimizing risk. Real estate tends to show much less correlation to the day-to-day volatility – and the significant periodic disruptions – inherent in the stock and bond markets. Net lease properties in particular are viewed as stable investments that exhibit less risk relative to other assets.
Inflation Hedge | The U.S. is experiencing the biggest spike in inflation in years across a broad number of categories, including food, energy and commodities. But hard assets, like real estate, tend to keep pace with rising prices and maintain their intrinsic value.
The proposed legislation looking to limit Section 1031 as it is written today is certainly a concern and merits attention if and when it comes before lawmakers. But investors should not allow a single policy to fully guide their investment decisions. With or without a change to Section 1031, savvy investors will continue to choose investment properties for their risk-reward profile, portfolio diversification qualities and other appealing characteristics and benefits when compared to other asset classes and investment alternatives.