The Impact of Tax Incentives on Investment:

A Cost-Benefit Analysis of Real Estate Tax-

Deferred Exchanges

David C. Ling & Milena Petrova

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The Impact of Tax Incentives on Investment: A Cost-
Benefit Analysis of Real Estate Tax-Deferred Exchanges

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 Current Price of Relinquished Prop.
Acquisition Price
of Relinquished
Property
Appreciation Amount taxable in a fully
taxable sale
Depreciation
Adjusted Tax Basis

0 1 2 3 4 5 6 7 8 9 10 Year

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 Exchanges are performed under Section 1031 of Internal
Revenue Code, which states that:

"no gain or loss shall be recognized if

property held for productive use in trade
or business or for investment is exchanged
solely for property of a like kind to be
held either for productive use in trade or
business or for investment"
 Current Price of Relinquished Prop.
Acquisition Price
of Relinquished
Property
Appreciation Amount of deferred gain

Depreciation
Adjusted Tax Basis

0 1 2 3 4 5 6 7 8 9 10 Year

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 Conserve cash by deferring recognition of realized gain
Deferred taxes are akin to interest free loan from Treasury

MV mtg. amount w/o exchange with exchange

Asset Preservation Incorporated (www.apiexchange.com)

 Strategically alter RE holdings w/o incurring taxes-
consolidation

Asset Preservation Incorporated (www.apiexchange.com)

 Strategically alter RE holdings w/o incurring taxes-
change markets or property types

Asset Preservation Incorporated (www.apiexchange.com)

 Must be an exchange -- i.e., a reciprocal transfer of property
Both assets must be held
for productive use in a trade or business, or
as an investment
Does not apply to personal residences (Section 1034)
Must involve "like-kind" property
RE for RE meets like-kind requirements, regardless of any
improvements/quality
 Simultaneous two-way exchange is NOT required
Taxpayers can exchange out of current property before a
replacement property has been identified
Cash from sale of relinquished property has to be parked
at a qualified intermediary (QI)
Taxpayer then has
45 days to identify replacement property(s)
Balance of 180 days to complete exchange
 You take your old depreciable basis AND depreciation
deductions with you into new property
Any additional basis in replacement property due to paying "boot is
recovered using SL depreciation over 27.5 or 39 years
The Impact of Tax Incentives on Investment: A Cost-
Benefit Analysis of Real Estate Tax-Deferred Exchanges

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 Recent tax reform proposals & Presidents recent budgets
would repeal or limit exchanges
Why? Elimination is seen as a potential source of tax revenue
JCTs tax expenditure estimate for 2014-2018 was $99 billion
In 2014, Real Estate Roundtable (RER) issued a call for
research proposals to evaluate effects of eliminating
exchanges
RER (http://www.rer.org) is an industry coalition of
leading publicly-held & privately-owned RE firms, along
with the major RE trade associations

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The Impact of Tax Incentives on Investment: A Cost-
Benefit Analysis of Real Estate Tax-Deferred Exchanges

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 Prior to credit/RE crisis, 80% percent of CRE transactions
on West Coast of U.S. involved use of an exchange
(McLinden, 2004)
Over 1999-2005 sample, Ling & Petrova (2008) report:
32% of apartment transactions involved an exchange;
corresponding % for office sample was 20%
Use decreased significantly during recent credit/RE crisis
More widely used in high tax, Western states

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 Relatively inexpensive properties dominate market for RE
exchanges
According to the Federation of Exchange Accommodators (FEA):
Sale price of relinquished property was < $500,000 in 36% of all exchange
transactions in 2011
Sale price < $1,000,000 in 59% of all transactions in 2011
Anecdotally, largest QI reported the median proceeds from sale of a
relinquished property was $400,000 in 2015

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The Impact of Tax Incentives on Investment: A Cost-
Benefit Analysis of Real Estate Tax-Deferred Exchanges

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 Assume a replacement property of equal value has been
identified
Investor expects to hold replacement property for, say, 10
years
Two options:
1. Sell relinquished property-buy replacement property
Sell-purchase strategy
2. Exchange out of relinquished property into replacement property
Exchange strategy

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 INCNPVt = PV of net cash flows (CFs) if taxpayer uses exchange strategy
- PV of net CFs if taxpayer uses sell-purchase strategy

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 INCNPVt = PV of net cash flows (CFs) if taxpayer uses exchange strategy
- PV of net CFs if taxpayer uses sell-purchase strategy

deferred tax liability in year t

reduced PV of annual
depreciation deductions t

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 Price of Replacement Prop. =
Acquisition Price Current Price of Relinquished Prop.
of Relinquished
Property
Appreciation Tax basis if use sell-purchase strategy

Depreciation
Adjusted Tax Basis

Tax basis if use exchange strategy

0 1 2 3 4 5 6 7 8 9 10 Year

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 INCNPVt = PV of net cash flows (CFs) if taxpayer uses exchange strategy
- PV of net CFs if taxpayer uses sell-purchase strategy

deferred tax liability in year t increased depreciation

recapture tax on taxable sale of
replacement property

reduced PV of annual
depreciation deductions t

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 Price of Replacement Prop. =
Acquisition Price Current Price of Relinquished Prop.
of Relinquished
Property
Appreciation

Depreciation Deferred depreciation recapture

Adjusted Tax Basis

0 1 2 3 4 5 6 7 8 9 10 Year

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 INCNPVt = PV of net cash flows (CFs) if taxpayer uses exchange strategy
- PV of net CFs if taxpayer uses sell-purchase strategy

deferred tax liability in year t increased depreciation

recapture tax on taxable sale of
replacement property

reduced PV of annual increased capital gain tax on

depreciation deductions t taxable sale of replacement
property

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 Price of Replacement Prop. =
Acquisition Price Current Price of Relinquished Prop.
of Relinquished
Property
Deferred capital gain
Appreciation

Depreciation
Adjusted Tax Basis

0 1 2 3 4 5 6 7 8 9 10 Year

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 INCNPVt = PV of net cash flows (CFs) if taxpayer uses exchange strategy
- PV of net CFs if taxpayer uses sell-purchase strategy

deferred tax liability in year t increased depreciation

recapture tax on taxable sale of
replacement property

reduced PV of annual increased capital gain tax on

depreciation deductions t taxable sale of replacement
property

Note: CFs from rental operations & sale in year n do not affect INCNPVt
INCNPVt initial tax savings (TDS)
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 Price of relinquished = price of replacement property
Mortgage debt: same for relinquished & replacement property
Selling cost in fully taxable sale: 3% of relinquished propertys sale price
Exchange costs: equal to selling costs of a fully taxable sale
Ordinary income tax rate: 39.6%
Depreciation recapture tax rate: 25%
Capital gain tax rate: 20%
After-tax discount rate: 6%
Non-depreciable land portion of relinquished & replacement propertys
original tax basis: 20%(no personal property)
Relinquished & replacement property are both non-residential real
property
Other key assumptions: # of years since acquisition of relinquished
property (HOLD1), annualized rate of nominal price appreciation since
acquisition of relinquished property (1), expected holding period of
replacement property (HOLD2).
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The Impact of Tax Incentives on Investment: A Cost-
Benefit Analysis of Real Estate Tax-Deferred Exchanges

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 Individuals, corporations, & partnerships using like-kind
exchanges must include a completed Form 8824 with their
federal tax return
Information is compiled & distributed by U.S. Treasury
Total deferred gains on all like-kind exchanges = $61.6
billion in 2012; averaged $63.9 billion 2003-2012
Buthow much is CRE?
$18.8 billion according to most recent IRS data

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 Assume deferred CRE gains in 2012 would have been taxed
at average federal rate of 21% in a fully-taxable sale
21% = weighted average of 20% capital gain tax rate & 25%
depreciation recapture tax rate
Implies deferred CRE tax liabilities = $4.0 billion in 2012
$4.0 = 0.21 x $18.8 billion
But$4 billion overstates benefit to investors because it
does not incorporate tax consequences subsequent to year of
exchange

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 Recall incremental NPV of an exchange equation.

deferred tax liability in year t increased depreciation

recapture tax on taxable sale of
replacement property

reduced PV of annual increased capital gain tax on

depreciation deductions t taxable sale of replacement
property

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 Our analytical model of net tax benefits includes these
important future tax impacts
Estimated range of benefits to taxpayers in 2012?
$1-$2 billion in increased wealth
What if assumed 6% after-tax discount rate is too high?

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The Impact of Tax Incentives on Investment: A Cost-
Benefit Analysis of Real Estate Tax-Deferred Exchanges

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 If Treasurys opportunity cost is < CRE owners, cost of an
exchange to Treasury is < corresponding benefit to taxpayer
Given Treasurys near zero opportunity cost, this wedge
between net benefit to taxpayers & cost to Treasury is
significant

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 Calculations assume taxpayers would have disposed of their
properties in fully taxable sales even w/o ability to exchange
Buttaxpayers would delay transactions, driving Treasury
revenue gains down significantly
Dynamic estimate of PV of lost Treasury revenue?
$100-$200 million.?

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 Ernst & Young (2015) estimates elimination would reduce
GDP by $8.1 billion each year & reduce labor income by $1.4
billion
Assuming increased tax revenues from elimination are used to finance
a revenue neutral reduction in corporate income tax rates

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The Impact of Tax Incentives on Investment: A Cost-
Benefit Analysis of Real Estate Tax-Deferred Exchanges

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 Buyers pay more for replacement properties when
completing an exchange
Capital expenditures in replacement exchange properties
tend to be higher than in regular acquisitions following a
taxable sale
Evidence of increased investment
Exchangers use less leverage to acquire replacement
properties compared to ordinary acquisitions

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 Holding periods for properties disposed through 1031
exchanges are shorter
Availability of exchange increases liquidity
Most replacement properties are subsequently sold in fully
taxable sales
In 88% of our sample, investors disposed of properties acquired in a
1031 exchange through a fully taxable sale

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The Impact of Tax Incentives on Investment: A Cost-
Benefit Analysis of Real Estate Tax-Deferred Exchanges

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 Document widespread use of RE like-kind exchanges
Build a model of net (incremental) benefit of an exchange
As a % of property value: 2%-10%
Do exchangers often overpay for replacement properties?
As a % of deferred tax liability: 10%-60%
Estimate elimination would produce small increases in the
PV of tax revenue
Static estimate: $1-$2 billion/yr.
Dynamic estimate: ??? ($100-$200 million/yr.)
Elimination would primarily affect small & medium size
investors/properties

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 Elimination of RE like-kind exchanges will likely lead to:
Decrease in $ amount of RE investment (including CAPX)
Increase in investment holding periods (decrease in liquidity)
Increase in use of leverage
Negative effects would be larger in markets where
exchanges are widely used

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The Impact of Tax Incentives on Investment:
A Cost-Benefit Analysis of Real Estate Tax-
Deferred Exchanges

David C. Ling & Milena Petrova

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