Commercial real estate investors have long counted on 1031 Exchanges as a reliable investment strategy. However, the sun is setting for investors and property owners in California who are faced with the prospect of making decisions amidst volatile capital markets conditions and in uncertain economic times. Meanwhile, the 1031 Exchange rule continues to face a potential cut at the federal level.
The 1031 Exchange rule has been on the chopping block for decades, as those in the commercial real estate industry wonder if this is the year it gets axed. It remains a valuable tool to encourage and promote sales transactions and transfers. Those who argue for retaining the rule say if it is removed, sales volumes would be impacted. Investors would likely hold onto assets longer and the tax basis would remain low, which runs counter to removing the 1031 Exchange rule.
The deadline for identifying and closing 1031 Exchanges in the Golden State is fast approaching on October 16, 2023, after being extended due to natural disasters that occurred in the state. That means those who counted on the stalwart regulation for decades when buying and selling commercial real estate must weigh several new factors in their investment decisions.
The deadline is expected to create a new sense of urgency for some, which could lead to an uptick of activity. Eric Paulsen, Kidder Mathews Regional President of Brokerage in Southern Californian & Arizona, says, “I don’t see a flurry coming, as there are no positive or negative consequences for the October deadline like we had with the ULA “Mansion Tax” in Los Angeles. The concept of a 1031 Exchange is still the same in that you need to be able to identify a good property to trade into.”
Investment Approach & Considerations
The primary benefit of 1031 Exchanges has been that it allows investors to roll investment returns/profits and the taxes from a property they sold into a new property, provided certain conditions are met. The benefit of this system has allowed continued investments to occur as investors found success, created value, exited one asset, and graduated on to others — thus assembling a portfolio of properties and building wealth.
By delaying paying taxes until a later time, 1031 Exchanges have also created a complex situation for investors because buying and selling commercial assets isn’t the same as going to the supermarket to buy eggs. Investors need to pay close attention to shifting market conditions and time the transaction accordingly. Often, properties a 1031 Exchange buyer needed to trade into weren’t readily available or the amount a seller was willing to accept for a property was much higher than buyers were willing to pay. In 2023, financing has been more challenging to obtain, and that’s created issues for upleg buyers. 1031 Exchanges aren’t without complications, yet they have served to encourage investment.
These exchanges are time sensitive — giving investors 45 days to identify suitable upleg or new properties, and a total of 180 days to close escrow on the new property.
Cost of Delays
It is important to be aware of the coming changes and deadlines pertaining to identifying properties and closing deals because if an investor misses any of the deadlines, their exchange could be invalidated and they would be required to pay taxes on the capital gains. That’s even more complicated if an investor has been exchanging in and out of properties for years and multiple times, which is possible, and their capital gains could be massive.
Should investors fail to move quickly, they could lose out on the benefits that had been created under the 1031 Exchange system. That could mean heavy penalties, higher property tax bills, or missing opportunities.
“For those who sold a property in the past year and didn’t identify a replacement property they’re going to be facing a potentially hefty tax bill,” says David Evans, a Kidder Mathews multifamily specialist in Los Angeles.
The future implications are equally complex and perplexing for investors. Under the Tax Cuts and Jobs Act, Section 1031 now applies only to exchanges of real property and not to exchanges of personal or intangible property. An exchange of real property held primarily for sale still does not qualify as a like-kind exchange.
There are potential future options such as a proposed federal law for “capped deferral” for 1031 Exchanges, yet that isn’t likely to be finalized soon. According to Kidder Mathews’ investment specialist Jay Bennett and Holly Yang, CCIM in Bellevue, Washington, “The largest changes that continue to be discussed are the threats to capping the 1031 Exchange at a federal level. This was proposed by Obama and again by Biden in the 2023 and 2024 budgets. The proposed cap from the Biden Administration is a $500,000 limit per individual ($1 million if married filing jointly). This will continue to be a point of debate between the two parties moving forward.”
Investors should consider adjusting their strategy either way. The tax bill is still there, and investors are just executing a 1031 Exchange to delay paying the taxes. Paulsen advises, “Don’t wait and don’t get caught up in the ‘I refuse to pay taxes’ mentality. If you can’t find a suitable exchange property, pay the taxes. Don’t throw good money after bad just to avoid taxes.”
Paulsen notes that he’s “seen too many times where transferring into the upleg property turned out to be a very bad decision, and the investor ended up having to invest additional money into the property only to see it sold below the acquisition price, all just to delay paying taxes. Paying the taxes would have been a better financial decision.”
Evans advises investors to consider “putting their proceeds in tax deferment strategies such as a DST if they cannot identify a suitable replacement property for their investment needs.”
Bennett and Yang’s advice for investors is to “make sure you surround yourself with qualified professionals to help guide you through this process. We work extensively with 1031 Exchange facilitators who know the process like the back of their hand. Having a team of professionals helping you is the best way to mitigate risk of the changing landscape.”
Ultimately, commercial real estate experts don’t envision a deadline flood of 1031 Exchange transactions, mainly because the rule hasn’t substantially been changed, just the date of extension. In this case, the 1031 Exchange deadline is merely a delay in California and it is still set against the backdrop of a high interest rate environment that currently exists.
Paulsen adds, “The market is not doing anything to make it a better opportunity in October than it is today. Having said that, humans by nature seem to be last minute term paper writers. We may have had months, but we end up staying up all night the night before it is due to write it. We may see some of that in California, but that is just poor planning and most likely will result in investors making bad decisions.”
President & COO
Stay in the know and subscribe to our monthly West Coast Market Trends report and our quarterly market research.