Here’s One Way to Avoid Taxes If the 1031 Is Eliminated

Commercial real estate professionals got worried in 2021 when the Biden administration floated its proposals to cut big tax reduction strategies, including 1031 like-exchanges. Congress didn’t move them into law, generating a giant collective sigh of relief in the CRE industry.

But the recent White House budget shows that the administration would still love to get rid of the 1031 by making it only eligible for a top property value of $500,000 for an individual and $1 million for a couple. (At current property prices, it’s not clear how often even small-time investors would be able to take advantage.)

Many professionals doubt that the necessary changes will make their way through Congress. Then again, only recently did a bill that would make daylight savings time permanent get through the Senate without the senators even realizing what they were agreeing to, as NPR and other outlets noted..

Just in case, it turns out there may be a way to offset the potential tax issues that would work for at least some by working with a REIT.

“This could actually be a boon for public REITs,” Jahn Brodwin, senior managing director and co-leader of real estate solutions at FTI Consulting, tells GlobeSt.com. That’s because they offer a strategy to do a type of swap without triggering a tax event.

“For a lot of them, the trust itself owns the operating partnership units in an operating partnership and the REIT happens to be a big partner,” Brodwin says. “Now say you and a couple of friends own a property together in a partnership, you want to sell it, and you don’t want to pay the taxes.”

Instead of turning to a 1031 exchange if taxes were going to be high, there’s the potential to do a different type of swap. Effectively, your asset holding company would merge with a REIT and in return you get an interest in the bigger operating entity. “It’s not a 1031, you didn’t sell the real estate but your ownership interest,” says Brodwin.

And yet, because you now have shares in a REIT, so long as it’s professionally and successfully managed, you know you’re going to get something in exchange. The REIT has to send out at least 90% of its taxable earnings.

“It’s just a tax deferral allowed under the code,” Brodwin explains. “You’re just becoming part of a bigger pie. Let’s say at some point down the road, you want to sell and want cash. You have a couple of ways to do that.” 

One is to convert the operating unit for stock, if the REIT is public, and sell. Or an investor could use the stock as collateral to borrow.