Limiting Like-Kind Exchanges Would Hurt Real Estate, Study Finds

Like-kind exchanges aid the commercial real estate sector by promoting increased investment, reducing holding periods and lowering leverage levels, according to an academic study released July 9.

Also known as 1031 exchanges after Section 1031 of the Internal Revenue Code, like-kind exchanges allow individuals and businesses to defer the payment of taxes on gains made on the exchange of property held for investment or in a trade or business for “like-kind” property.

The study, which was authored by David Ling, a finance professor at the University of Florida’s Warrington College of Business, and Milena Petrova, a finance professor at Syracuse University’s Whitman School of Management, examined the economic impact of repealing or limiting like-kind exchanges in real estate.

The study concluded that the effective tax rate on a commercial property investment would increase to 30 percent from 23 percent if like-kind exchanges were repealed. Repeal would also force real rents to increase from 8 percent to 13 percent before new construction would be economically viable.

Investors using like-kind exchanges acquired replacement property that was $305,000 to $422,000 more valuable than the original property, according to the report. Holding periods were about six months shorter on average.

The study also showed that replacement properties involved in like-kind exchanges have median loan-to-value ratios of 63 percent to 64 percent, compared with 70 percent for properties acquired in non-exchanges.

“Section 1031 helps real estate businesses grow and expand organically, with less debt,” said Jeffrey DeBoer, president and CEO of The Real Estate Roundtable, a sponsor of the study. As a result, property owners can channel more money back into upgrading and improving their assets, he added.

Meanwhile, the study found that in 88 percent of cases investors disposed of properties acquired in a 1031 exchange through a taxable sale, rather than continuously rolling them over. In fact, the study concluded that taxpayers paid “substantially” more  in tax when the replacement property was sold than would have been the case had the exchange not occurred.

The researchers analyzed more than 1.6 million transactions during an 18-year period.