Improving Canada's real estate investment and taxation policies - where's our 1031 exchange?
Unless you’ve had the opportunity to be involved with real estate investments in the United States, you may not know what a 1031 exchange is. Also called a like-kind exchange, this is a unique and progressive policy under the IRS that allows allows an investor to sell a property, reinvest the proceeds into a new property, then defer all capital gain taxes until a future date. It’s an extremely well-utilized policy designed to aid investors in not only building personal wealth, but to further encourage reinvestment of that wealth back into the market for bigger and better assets. It has the capability of promoting exchange in the market, and creating an environment where there are always new and fresh opportunities for those investing under this umbrella. So much so, that there is an entire market of buyers and sellers participating in 1031 exchanges throughout the United States.
So how is a 1031 exchange structured?
There are a few basic rules when an investor decides to sell their current asset and pursue a like-kind exchange.
A. Property Use
Both the existing property and the new property have to be held for investment, or business use. Properties held for investment can be either income producing (rental/leasing activities), or held for growth in value (capital appreciation). Properties held for business support the operation, and can be the physical real estate (e.g. warehouse building), or personal property used in the operation (e.g. manufacturing equipment); both will qualify for 1031 exchange.
B. 45 Day Identification Period
The purchaser has 45 days from the Closing of their existing asset to identify and nominate potential properties they may want to purchase. This written list must be signed and delivered to a qualified intermediary (QI) before the end of the 45th day. The IRS mandates that an independent QI must be utilized to prepare all legal documents for this exchange.
C. 180 Day Exchange Period
The purchaser then has 180 days from the Closing of their existing property to acquire one of the replacement properties specified to the QI.
D. Reinvestment Requirement (Equal-Or-Up Rule)
It’s important to note that in order to defer all of the capital gains on a sale, the investor must purchase a property that is equal or greater in value to the existing property; all cash proceeds must be reinvested in the replacement. However, it’s important to note that a property does not have to be exchanged for the same kind of property. Generally, it is expected that an asset is held for at least one to two years before sizing up, proving the intention is to hold for investment, though this is not concretely specified. The only minimum required hold period in section 1031 is a “related party” exchange mandating a minimum of two years.
Why is this policy so important in USA, and Canada?
I think it goes without saying that market factors weigh heavily on the trade volume of commercial real estate assets. In Alberta, where we have been experiencing a downturn for the past four years, the result has been a decrease in credit tenants, space absorption, and therefore, less quality investment opportunities for capital placement. Investors that possess quality income-producing assets are skeptical to sell because there are limited opportunities for reinvestment of cash proceeds, not to mention huge tax penalties if the asset has been held for any length of time. Having a policy like the 1031 exchange would promote investors, big and small, to create a more flourishing investment market with continuous availability to high-calibre, income-producing assets.
A few years ago, NAIOP co-sponsored a study that analyzed ‘The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate’ in an attempt to inform policy makers of its importance in the American market. The main finding was that without this hugely important tax deferral mechanism, taxpayers would hold their properties longer and dispose of them less frequently, while furthermore forcing more reliance on debt financing due to huge taxes on sale. This sounds a lot like the Alberta case study I just mentioned…
An analysis of the study, conducted by Acquiles Suarez, NAIOP Vice President of Government Affairs, found that Section 1031 like-kind exchanges result in:
Increased investment: Taxpayers who utilize a like-kind exchange on average acquire replacement property that is $305,000 to $422,000 more valuable than the relinquished property;
Increased federal tax revenue: In more than a third of exchanges, some federal tax is paid in the year of the exchange. Thereafter, like-kind exchanges result in added revenue because of the higher tax liability associated with increased investment in the real estate asset and greater value of the property following the initial exchange;
Less debt: In the case when the like-kind is for property that is close to or less than the original property, an exchange results in a 10 percent reduction in borrowing, or leverage, at the time of the acquisition of replacement property;
Increased economic activity and jobs: Properties acquired through a like-kind exchange are most often the subject of upgrades, capital expenditures, and improvements, resulting in additional economic activity that leads to more jobs.
Conversely, the impact of repealing Section 1031, aside from increasing taxes on real estate investors, would result in:
A drop in property values: In local markets and states with moderate levels of taxation, commercial property price would have to decline 8 to 12 percent to maintain required equity returns for investors expecting to use like-kind exchanges when disposing of properties;
Increased rents: Rents would need to increase from 8 to 13 percent before new construction would be economically viable. The effects would be more pronounced in high-tax states;
Fewer transactions: Exchanges increase liquidity in real estate markets. Properties involved in like-kind exchanges had significantly shorter holding periods than similar properties.
Source: blog.naiop.org
There is a reason that investment capital continues to flow out of Canada and into the United States in all industries. It is due to progressive policies like Section 1031, implemented to promote trade, development and growth. USA continues to develop and enact new policies that allow for tax breaks in return for deeper capital investment. Most recently, in 2017 a new policy was implemented to to encourage long-term investment into Opportunity Zones, aka low-income urban and rural communities nationwide through tax incentives, but I’ll leave this topic for another time. Ultimately, it’s time for Canada to pull up its socks and create an environment that promotes trade and investment, no matter the market conditions.