One big factor impacting the private-capital NNN commercial real estate market is the possible removal of IRS Code Section 1031, which allows NNN landlords to defer capital-gains taxes on the sale of a property by reinvesting the proceeds in a “like-kind” property within 6 months. The exchanges are an important mechanism for the private-capital marketplace, largely the enclave of wealthy individuals, family offices and boutique private-equity firms seeking to generate cash flow and create inter-generational wealth.
The Biden Administration has proposed ending 1031 exchanges to help fund proposed child care and family-leave legislation. There also are rumors of increasing capital-gains taxes, which would hurt NNN property owners more but would still cut into private-capital profits. Although this proposal doesn’t appear to completely eliminate the 1031 exchange, it has significant constraints, and most NNN property owners would not be able to take full advantage of the tax break.
The Biden 1031 proposal would treat the exchanges of NNN commercial property used in a trade or business (or investment) similarly to sales of property, resulting in fewer distortions. This revision could increase the progressive nature of the tax and raise revenue for the U.S. Treasury. Note that this is just a proposal and may not ultimately translate into law.
At present time, owners of appreciated NNN commercial property used in a trade, business or held for investment can defer the capital gain on the exchange of the property for similar property. As a result, the tax on the capital gain is deferred until a future recognition event, provided that certain conditions are not violated. The proposal would allow the deferral of capital gain up to the amount of $500,000 per taxpayer ($1.0 MM for married individuals filing a joint return) per year for real property exchanges that are “like-kind”. Any capital gains accruing from like-kind exchanges greater than $500,000 (or $1.0MM for married individuals filing a joint return) during a tax year would be recognized by the investor in the year the investor transfers the real property subject to the exchange. The current Biden proposal would likely be effective for 1031 exchanges completed in tax years beyond, Dec. 31, 2021.
Conventional market wisdom is such: if private-capital investors don’t have access to favorable tax treatments like the 1031 exchanges, they are less likely to sell properties in the future. While institutional investors typically focus on IRRs, private-capital investors can hold assets without considering a time horizon. NNN property owners whose cost of capital increases because of higher capital gains taxes likely will hold properties longer. From a macro-economic perspective, recycling capital by exchanging properties, keeps prices lower and increases deal-flow and, tax revenues are more consistent, yet keeps market liquidity elevated. This would not happen under current Biden proposal for 1031 exchanges greatly harming at least one-third of the $25 trillion commercial real estate market.
For a smooth and successful transaction with impeccable facilitation for your potential 1031 exchange, reach out to your trusted advisors and 1031 navigators led by Broker Robert Gamzeh at the Triple Net Investment Group. (We ask our readers to call or write to their congressman and/or senator to vote against the Biden 1031 proposal moving forward in both chambers.)