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Real estate investors wary of tax changes; say limiting Section 1031 would slow down sector

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“What is your favorite section of the Internal Revenue Code?”

It's an odd question for most people, but not for many real estate investors and professionals. Without hesitation, they would point to Section 1031, which enables someone to sell a property and defer taxes on capital gains if the proceeds are used to buy another like-kind property soon thereafter.

It’s why so-called 1031 exchanges have long been favored by the commercial real estate sector. And why they have long been wary of seeing them go.

The provision has been the target of federal lawmakers seeking to close tax loopholes and find new revenue sources in the past. But, this year, experts are raising alarm that the threat is more than empty chatter.

“We’re hearing it from our clients and their tax advisers,” said Ted Zangari, chair of the real estate department at the Newark-based law firm Sills Cummis & Gross. “They’re coming in and they’re saying, ‘We want to unload now. We’re not sure if this deferral is going to be around in a year.’

“And, not only that, it doesn’t hurt that they’re not selling at a low point in the market — they’re selling at a relative high point in the market.”

Zangari and other experts point to recent tax reform plans being floated in Washington, D.C. For instance, the Obama administration’s proposed 2016 budget calls for limiting the tax deferral in a 1031 exchange to $1 million annually, per taxpayer.

That comes after former House Ways and Means Committee Chairman Dave Camp unveiled a bill last year that called for repealing 1031 exchange rules, in an effort to raise revenue to finance a lower corporate income tax rate. And Zangari noted that Paul Ryan, current chair of the committee, has said he wants to roll out a major tax reform bill by Congress’ August recess.

Those are all prospects that don’t sit well with the real estate community.

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“The 1031 (exchange) stimulates economic growth and allows investors to grow and expand,” said Thomas McConnell, managing principal of Redwood Realty Advisors. “And creating limits on that rule would essentially freeze the commercial real estate sector.”

McConnell, whose firm is based in Hasbrouck Heights, estimates about 75 percent of its transactions are 1031 exchanges. The tool often encourages owners to trade up — from apartments and other management-intensive properties to more hands-off assets — while creating opportunities for first-time investors.

He said curtailing 1031 exchanges will create “a longer hold period (and) it will reduce the velocity of investments — and there will be just less capital deployed into the economy.”

Section 1031 like-kind exchange rules, which have been in effect since 1921, also apply to other asset types and industries such as artwork, construction equipment and transportation. Under the tax code, a seller has up to 45 days to identify a replacement property, and another 135 days to close on it

A report released in March by Ernst & Young lobbied against proposals to repeal the rules, estimating the GDP would fall by $8.1 billion each year, while overall investment in those affected areas would fall by $7 billion.

Its authors said such a policy change “is at cross-purposes with some of the objectives of tax reform,” noting that it could in fact help lower the corporate income tax rate, but those gains would be more than canceled out because a repeal of Section 1031 would discourage investment.

That echoes the concerns of real estate professionals who say 1031 exchanges are as attractive as ever.

“We find that the market is pretty ripe, and people are looking for ways to take the proceeds that they have from the sale of real estate and shelter its tax by reinvesting it in like-kind exchanges through Section 1031,” said Jacob Frydman, chairman and CEO of United Realty Trust Incorporated.

Across New Jersey, experts say interest in 1031 exchanges has picked up as the state moves further from the real estate downturn. Jose Cruz, a senior managing director with the brokerage firm HFF, said “it’s commensurate with deal activity” in the investment sales market.

“If you go back to 2010, 2011, there weren’t as many transactions being completed, so you couldn’t have as many 1031s,” said Cruz, who is based in Florham Park. “Now that in ’14 and ’15, the volume of activity has really moved to a significant pace, there’s many more 1031s out there. I think it’s just the volume of deals.”

As for the prospect of not being able to do 1031 exchanges, Frydman has heard the chatter before.

He conceded now that, with an $18 trillion national debt, “the government is going to consider ways to generate revenue, but there are also some sacred cows out there.”

“These 1031s are pretty ingrained in our system,” Frydman said. “I don’t have a crystal ball, but I would hate to see it happen.”

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