A popular commercial real estate tax break used by hotel companies such as Hilton could be going away soon, even if a federal tax overhaul isn't passed this year.
In the offing is the elimination of the 1031 exchange provision, which allows sellers of commercial real estate to defer capital gains taxes by taking proceeds from a sale and investing it in "like-kind properties."
It's a tactic heavily used by sellers of hotels as a preferred method for offsetting the sometimes exorbitant taxes they'd otherwise have to pay. When, for example, Hilton sold the Waldorf Astoria in New York to Anbang Insurance Group in 2015 for $1.95 billion, it took the proceeds from the sale to acquire five hotels: the Hilton Orlando Bonnet Creek, Waldorf Astoria Orlando, The Reach and Casa Marina Waldorf Astoria Resorts in Key West and Parc 55 in San Francisco.
The 1031 exchange provision is also widely used by hotel real estate investment trusts, which buy and sell hotels to maximize their portfolios with properties that are profitable for shareholders. Hersha Hospitality Trust, for one, has funded many of its acquisitions this way.
As The Wall Street Journal first reported, Congress, in order to fund some semblance of a tax rate cut, is looking at snipping the 1031 exchange to finance it. The provision was already threatened by the House Republicans’ tax-overhaul plan called “Better Way,” which reportedly did include some "attractive provisions" for the real estate industry. However, since it's less clear now that Better Way will pass this year, the real estate industry is poised to not only lose the 1031 exchange provision, but any other concessions.
The Wall Street Journal points to the Joint Committee on Taxation, which in 2014 estimated that repealing like-kind exchanges would raise $40.6 billion in additional tax revenue over one decade.
Advisory firm Green Street told The Real Deal that like-kind exchanges are used in between 10 and 20 percent of all commercial real estate transactions.
If the provision is, in fact, eliminated, it could "cause a lot of transactions not to occur," Jeffrey DeBoer, chief executive of lobbyist group Real Estate Roundtable, told The Wall Street Journal.
Impact on Hotel Transactions
This includes hotel sales, which, according to JLL, totaled $29.1 billion in the U.S. in 2016. JLL predicts that 2017 volumes will amount to $29 billion, mirroring last year.
In speaking to hotel industry executives, to a man, they say the elimination of the 1031 exchange would be deleterious to hotel sales volumes.
"It would likely negatively impact transaction volumes across all investment property types, making sell vs. hold analyses different since it would be more costly to sell," said Ryan Meliker, a managing director at financial services firm Canaccord Genuity, concentrating on equity research, REITs and lodging. "There would be fewer assets for sale, which could drive values up, but there would also be less capital chasing transactions, which would drag values down."
The irony is that small businesses, championed at all turns by the Republican Party, have the most to lose if 1031 exchanges are eliminated. If a real estate owner doesn't have the cushion of deferring capital gains taxes, then not only is there less incentive to sell, but not reinvesting that money stymies job growth.
"It's hard to believe that Republicans are going to do something that will affect small businesses in a negative way. They say they are a friend, but will take away a huge tax vehicle," said Steve Kirby, managing principal with brokerage firm Mumford Company and based in Atlanta. Kirby was so incensed with the proposed termination of the program that he reached out and complained to his state's senators.
Capital gains taxes range depending on income brackets, but can be as high as 20 percent.
Kirby agrees that the impact would also be felt in hotel sales volumes, where he makes his living in brokering the sale of hotels. "Sellers potentially are not going to want to sell because they might not have a place to put their money when they sell it," Kirby said.
To be sure, the 1031 exchange provision is a tex-deferral program, not a tax-elimination program. At some point, those taxes will be paid, but it allows investors to kick the can down the road.
Congress enacted the 1031 exchange statute in 1921 for two main purposes: 1. To avoid unfair taxation of ongoing investments in property and 2. To encourage active reinvestment.
For foreign owners of commercial real estate, eliminating the 1031 exchange also has implications. For "non-resident aliens," gains on the sale or other disposition of U.S. real estate are considered U.S. source income and subject to U.S. income tax under FIRPTA rules.
While no legislation has officially been passed yet, investors must bear in mind the consequences of losing the 1031 exchange program, particularly now as there are signs that cap rates have bottomed out and are now trending upward.