1031 Elimination: Potentially 'Devastating' For Multifamily Investment With No Upside

The multifamily space survived the 2020 coronavirus pandemic mostly unscathed despite fears over tenants' ability to pay. That has boosted its appeal as an investment target, but a provision in President Joe Biden's tax plan could stymie deal flow and could even trickle down to fewer renovations to older properties and a deterioration of the housing stock.

The White House has proposed a tax and spending plan that would end tax deferments on most 1031 exchange transactions effective Dec. 31, 2021. 

The move would terminate what's traditionally called like-kind transactions that allow commercial building owners and investors to sell their assets and deploy any capital gains into another multifamily or commercial property to delay payment of the tax. The plan has not been approved by Congress and could be adjusted or killed.

A study from Ernst & Young estimates the 1031 exchange program drives $4.4B in investments and related consumer spending, and firms participating in or supplying like-kind deals support 568,000 American jobs and $27.5B in wages and benefits. All told, E&Y estimates the existing 1031 exchange rules generate $55.3B in economic impact.

Those in the industry fear the program's elimination will cause multifamily transactional volumes to tumble as more investors sit on their assets, negating any of the taxable gains the Biden administration hopes to realize at the point of sale. 

"They can raise the tax rate as high as they want, but what it's going to come down to is there are going to be a lot of apartment investors who are not going to be able to sell," Springhill Real Estate Partners co-Managing Principal William Brown told Bisnow. 

"I would suggest between 25% to 30% of people that if they have to sell something and pay taxes, they are just not going to sell," said Ron Raitz, president of Atlanta Deferred Exchange Inc., an intermediary for 1031 exchange deals. "They are going to sit on the sidelines and that starts impacting supply and demand. It may impact cap rates across the board, and multifamily, in particular, has been one of the hottest areas along with industrial in the last three years, so it will definitely cool that down."

The end of 1031s also could mean price deflation and a drop in value-add plays, and some investors may decide to get out of a property altogether before the proposed change kicks in next year, Ernst & Young suggests in its report. 

A large portion of the economic impact will stem from a slowdown in the number of players in the multifamily space who will be motivated to move capital into property renovations or adaptive reuse plays to create more housing when they do not have the opportunity to defer the taxes, according to Brown. 

"What a lot of my contemporaries do is they trade into the properties," Brown said. "They will trade 50 [units] for 100, and when they buy the 100 units, they are going to renovate the units."

The economic impact of this type of value-add renovation is anywhere from $10K to $12K per unit, including buying materials and hiring people to do the renovations, Brown said.

While the impact on total housing supply is unknown, the quality of housing could certainly suffer with 1031s playing a big role in property renovation deals or value-add purchases, Marcus & Millichap Senior Managing Director of Investments/Executive Director Al Silva said. 

"There are a large number of deals done every year that are driven by this 1031 exchange strategy, and fewer deals happening does mean fewer [properties] undergoing renovations," Silva said.

Silva estimates between 10% and 20% of Marcus & Millichap's multifamily transaction volume involves like-kind transactions. 

"What keeps the market mostly healthy for everybody is when you have capital moving in the market," Raitz said. "1031s kind of act as the grease or oil, particularly in down markets wherein situations like now you have to reposition assets."

It is a misconception that the end of 1031s is an elimination of an elite tax hole for the 1%, Raitz and Brown say. The experts suggest small-time and entrepreneurial-minded investors — some with as little as one property — could end up taking a hit to their planned retirements by losing the 1031 exchange. 

"I think the bottom line is whether they pass it for April or December, let's just hope they don't pass this thing," Brown said. "It would be devastating to the apartment business, local municipalities; and, once again, they are not going to collect the kind of income they think they are going to collect because people will not be able to afford to sell."