New Report Quantifies Vast Economic Benefits of “Like-Kind” (Section 1031) Exchanges; Schumer, Portman Call for FIRPTA Reform in Senate Report on International Taxation
• Treasury officials, Members of Congress briefed on new report quantifying economic benefits of like-kind (Section 1031) property exchanges — including increased investment and job creation, strong property values, reduced use of debt financing
• Senate Finance Committee members Charles Schumer (D-NY) and Rob Portman (R-OH) urge inclusion of House FIRPTA legislation in any international tax overhaul
• Portman, Schumer also propose one-time tax on repatriated corporate earnings — as potential means of addressing HTF/ infrastructure funding shortfall
• McConnell: HTF authorization bill expected to reach Senate floor next week
A new economic analysis of more than 1.6 million real estate transactions spanning 18 years highlights the critical role that “like-kind” property exchanges play in fostering U.S. economic growth, safeguarding property values and stabilizing rents. The report, which was sponsored by The Roundtable and 15 other real estate-related organizations, was the subject of a Capitol Hill briefing today for congressional staffers.
As the study confirms, like-kind exchanges (authorized under Section 1031 of the U.S. tax code) contribute to a more dynamic real estate sector by eliminating potential “lock-in” effects (particularly in the case of under-performing assets). Taxpayers’ ability to exchange one business or investment property for a similar one fosters increased investment and reinvestment activity; allows real estate owners to better allocate resources; and decreases debt levels in commercial and multifamily real estate transactions.
“Like-kind exchanges are associated with increased investment, shorter holding periods, and lower leverage,” said study co-author Dr. David Ling, finance professor at the University of Florida’s Warrington College of Business and past president of the American Real Estate and Urban Economics Association.
On average, replacement properties in “1031 exchanges” are worth $300,000–$400,000 more than the original properties — added value that is re-invested into communities and that generates higher taxes when the property is ultimately sold. Likewise, the study shows properties acquired through like-kind exchanges are more likely to undergo building improvements and expansion, ultimately creating more jobs.
The study also illustrates the unintended negative economic impacts of proposals that seek to limit or repeal Section 1031 exchanges — and that view such exchanges through a narrow, “static” economic lens. This includes a proposal in President Obama’s FY2016 budget plan that would limit the deferral of taxable income on real estate exchanges to $1 million annually [Roundtable Weekly, Feb 6].
“Like-kind exchanges are associated with increased investment, shorter holding periods, and lower leverage,” said study co-author Dr. David Ling, right, finance professor at the University of Florida’s Warrington College of Business and past president of the American Real Estate and Urban Economics Association.
“Although the present value of [federal] tax revenue losses associated with real estate like-kind exchanges is relatively small in magnitude” — an estimated $0.2 billion to $1.4 billion in 2011, according to the study — eliminating such exchanges “would disrupt many local property markets and harm both tenants and owners,” causing a cascade of negative macroeconomic effects.
For example, in local markets and states with moderate levels of taxation, commercial property prices would have to decline 8–12 percent to maintain required equity returns for investors (if like-kind exchanges could no longer be used). This, in turn, would reduce the wealth of a large cross-section of households and slow or stop construction in many local markets.
Repealing 1031 exchanges would also lead to higher rents — reducing the affordability of commercial space for large and small tenants and, thus, reducing such businesses’ ability to invest in equipment or employees. Over time, for example, real rents would need to rise from 8–13 percent before new construction would be economically viable. The price declines and rent effects of eliminating real estate like-kind exchanges would be more pronounced in high-tax states.
Other ripple effects (resulting from a repeal of 1031 exchange rules) would include:
Higher taxes for thousands of commercial property owners
Reduced real estate market liquidity
• Longer holding periods, which would mean reduced real estate sales activity
As explained by the study’s other co-author, Dr. Milena Petrova, finance professor at Syracuse University’s Whitman School of Management, “Removing the exchanges would decrease property values and net investment, increase holding periods, and increase the use of leverage to finance acquisitions.”
Study co-author Dr. Milena Petrova, right, finance professor at Syracuse University’s Whitman School of Management, “Removing the exchanges would decrease property values and net investment, increase holding periods, and increase the use of leverage to finance acquisitions.”
She added, “These micro effects are likely to have macro-economic consequences as well by decreasing construction and investment activity in commercial real estate markets, which would depress employment in markets where like-kind exchanges are commonly used. It is critical to fully understand the positive economic effects of the like-kind exchange provision before considering any changes to the policy.”
Roundtable President and CEO Jeffrey DeBoer said the Ling-Petrova study “demonstrates how critical like-kind exchanges are to the health and vibrancy of real estate activity in the United States.”
As he explained, “Acquiring and improving commercial real estate requires large amounts of capital, and section 1031 helps real estate businesses grow and expand organically — with less debt. In short, like-kind exchanges allow property owners to put more of their earnings back into the private sector — hiring workers, upgrading and improving properties, and generating much-needed economic activity.”
The study, titled “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate” is available online at: http://www.rer.org/LKE/
A similar analysis released by Ernst & Young in March reached similar conclusions about the economic harm that would come from limits on like-kind exchanges.
Key Senators Urge FIRPTA Reforms as Part of Any International Tax Reform
In other tax news, Sens. Rob Portman (R-OH) and Charles Schumer (D-NY) this week called for reform of the Foreign Investment in Real Property Tax Act (FIRPTA) as part of any overhaul of U.S. international tax laws and regulations. Portman and Schumer are the co-chairs of a Senate Finance Committee working group that has been studying options for international tax reform. Their comments on FIRPTA came as part of a final report, issued July 7.
Roundtable President and CEO Jeffrey DeBoer, left, said the study “demonstrates how critical like-kind exchanges are to the health and vibrancy of real estate activity in the United States.”
Among other things, the senators noted FIRPTA’s discriminatory nature, explaining that foreign investors holding non-real estate investments in the Unites states (e.g. corporate stock) are not required to pay U.S. gains tax upon the disposition of these assets (as foreigner investors must do with real property holdings).
“As a result of this disparity in treatment, foreign long-term capital is discouraged from flowing into much needed infrastructure investments,” the report stated. The co-chairs went on to say that FIRPTA reforms pending as part of Brady-Crowley legislation in the House (H.R. 2128) should be included in any international tax reform package.
At a recent New York University (NYU) conference in Washington, Roundtable Vice President and Counsel Ryan McCormick said, “There’s a strong nexus between FIRPTA reform and getting additional investment — particularly on the private-sector side — into infrastructure” (Tax Notes, June 29).
The billions of dollars in anticipated foreign capital that would flow to the U.S. as a result of FIRPTA reform could also help with the refinancing of commercial mortgage debt.
In The Roundtable’s view, FIRPTA reform offers as an innovative potential means of addressing the shortfall in the Highway Trust Fund (HTF), whose latest stop-gap funding authorization is set to lapse on July 31.
Approximately $11 billion in revenue is needed to fund HTF through year-end; roughly $90 billion would be needed for a six-year reauthorization [Tax Notes, June 29; Politico, July 6] — widely viewed as the ideal timeframe for giving give states, regional planners and other stakeholders the certainty they need, with regard to major infrastructure projects. The uncertainty over federal funding is already jeopardizing construction projects and jobs in a number of states.
In other tax news, Sens. Rob Portman (R-OH), right, and Charles Schumer (D-NY), left, this week called for reform of the Foreign Investment in Real Property Tax Act (FIRPTA) as part of any overhaul of U.S. international tax laws and regulations.
Amid reports that the Senate may consider transportation funding legislation next week (Bloomberg, July 9), Schumer and Portman proposed a one-time tax on stockpiled overseas corporate earnings as a potential source of revenue for infrastructure modernization. However, their proposal, which draws on similar ideas outlined by President Obama and former House Ways and Means Chairman Dave Camp (R-MI), is unlikely to provide an immediate influx of money to the HTF (The Wall Street Journal, July 8).
Senate Majority Leader Mitch McConnell (R-KY) reportedly said that any changes to laws governing international tax matters should be part of a broader U.S. tax overhaul and that there isn’t enough time to come up with a wide-ranging tax overhaul before the HTF comes up for a Senate floor vote, likely next week (WSJ, July 8).
As part of their final report on international tax reform options, Schumer and Portman also proposed a U.S. “innovation box” (similar to what already exists in other countries) — offering tax breaks to companies that generate profits from patents and other intellectual property in the U.S.
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