1031 exchange transactions remain an important tax strategy in 2023, with a reasonable volume of transactions despite some challenging headwinds, including high interest rates and stagnant property valuations in some sectors.
As a quick reminder, a 1031 exchange is a tax strategy identified in Section 1031 of the Internal Revenue Code that allows a taxpayer to defer the payment of capital gains taxes that may arise from the sale of a business or investment property. Taxes may be deferred by using the sale proceeds to purchase “like-kind” real estate as long as the taxpayer satisfies certain conditions.
Reasons For Optimism
Across commercial real estate sectors, there are several factors that can help sustain a healthy volume of 1031 exchange transactions, which we believe suggests that 2023 may be a better year for the program than some predicted.
While the pace of rent growth experienced in 2022 has slowed for several “traditional” commercial real estate sectors, other property types like manufactured housing, student housing, and senior housing have significant supply-demand imbalances, which could help fuel strong rent growth.
High interest rates are likely to thin the pool of prospective buyers, which will put downward pressure on asking prices. This may motivate many sellers to capture their current highest value to avoid any further decline and look to other properties that may be more stabilized, including passive structures like the Delaware Statutory Trust, or DST.
The Tax Cut and Jobs Act of 2017 allows businesses to deduct a large percentage of the purchase price of an eligible asset upfront from the company’s tax liability – 80%, to be exact. The deduction percentage will decline by 20% each year until it is no longer available by 2026. This may motivate taxpayers to use a 1031 exchange in 2023 to take advantage of the maximum allowable deduction.
Estate Planning Focus
Aging business owners who have tired of managing property and wish to sell will likely continue to look to use 1031 exchanges to sell property in the most tax-efficient manner for their heirs. As an estate planning tool, 1031 exchanges allow for the transfer of property to heirs on a stepped-up basis, which is a tremendous motivator for owners who have owned property that has appreciated in value over decades.
The 1031 exchange has been used for more than 100 years by taxpayers seeking to preserve and grow the wealth they’ve accumulated from the appreciation of their property. And while transaction volume may change year-to-year depending on the market and economic conditions, we believe the 1031 exchange is one of the most valuable wealth accumulation strategies available to taxpayers and, even during challenging times, we expect exchange volume to remain strong.
Some of the risks related to investing in commercial real estate include, but are not limited to: market risks such as local property supply and demand conditions; tenants’ inability to pay rent; tenant turnover; inflation and other increases in operating costs; adverse changes in laws and regulations; relative illiquidity of real estate investments; changing market demographics; acts of God such as earthquakes, floods or other uninsured losses; interest rate fluctuations; and availability of financing.
This communication is not intended as tax advice. Past performance is not a guarantee of future results.