By Mard Naman
The commercial real estate industry breathed a huge sigh of relief when tax reform was passed last December: Two key provisions that are the lifeblood of the industry were preserved. This didn’t happen by chance or happen overnight. It was the culmination of years of hard work by the IPA and other organizations committed to protecting real estate and portfolio diversifying investments.
The provisions are Section 1031 like-kind exchanges and the net interest expense deduction. Section 1031 allows real estate investors to defer (not avoid) capital gains taxes when they sell one property and buy another. The interest expense deduction allows the interest on leveraged property to be deducted for real estate partnerships, LLCs, REITs and RICs.
Both were initially targeted for elimination with bipartisan support in Congress, and both would have been killed without the vigilance, lobbying and tenacity of the IPA and its coalition.
Section 1031 has broad use for real estate. If an investor sells a four-unit apartment building and buys a six-unit apartment, the investor can use Section 1031 to defer taxes. Or an investor can sell a manufacturing plant in Ohio or a farm in Montana and buy office space in Manhattan and get that tax-deferred benefit. It does not have to happen simultaneously — the investor can identify the new property within 45 days of selling the old and then complete purchase of the new property within 180 days.
Tax-deferred like-kind exchanges have been ingrained in the tax code since 1921, so you would not think they would be on the chopping block, but that was indeed the case in 2014 when Republican Congressman Dave Camp, then head of the House Ways and Means Committee, prepared a report on tax reform and recommended the elimination of Section 1031 and other existing tax preferences crucial to commercial real estate.
The reason? To help offset the cost of reducing the corporate tax rate. Reformers were looking for as many “pay-fors” as possible to help pay for the desired deep reductions in corporate rates. But they did not recognize the broader damage to commercial real estate and to the economy.
This started during the Obama administration and received broad bipartisan support. “You had Democrats, Republicans and the President, all on the same page that 1031 should be drastically changed or taken away,” says Dan Wagner, senior vice president, government relations with Inland Real Estate Group, and an IPA board member.
Additionally, they wanted to get rid of net interest expense deductions for real estate. “That’s the juggernaut that the commercial real estate industry was really looking at,” Wagner says. “As soon as the Camp stuff came out, it was like alarm bells going off.”
An Immediate Call to Arms
To get Republicans and Democrats to agree on anything in extremely partisan Washington, D.C., is rare, so this was a serious matter and an immediate call to arms for the IPA and numerous other impacted organizations such as the National Association of Realtors, Real Estate Roundtable, Nareit, International Council of Shopping Centers and Federation of Exchange Accommodators. It was a large, broad coalition.
No group had more at stake than the Federation of Exchange Accommodators, which, as qualified intermediaries, hold the money in Section 1031 like-kind exchanges until the purchase of the new property is completed. 1031s are their everyday business. “It’s like a bacon and egg breakfast,” Wagner says. “The chicken cares about it, but the pig is really committed.”
Wagner helped spearhead the fight against these changes. “We started this methodical process and we were relentless,” Wagner says. “Everybody was engaged.” They knew that Section 1031 was vital to economic growth. This was really a case of “If it ain’t broken, don’t fix it,” but could Congress be made to see that?
Section 1031 had been threatened before during previous tax reforms over the years. But this time around the IPA and its coalition had to become much more sophisticated, Wagner says. Right away the IPA helped pay for studies to show what it would mean on a micro- and macro-economic level if 1031 went away.
The studies clearly showed the huge impact that 1031 had on the velocity of the economy. Getting rid of 1031 would basically stop the transfer of property unless someone was forced to sell for financial reasons. “The studies showed there’s no incentive for anyone to sell their commercial property because they would get this huge capital gains hit,” Wagner says. “You would have a total shutdown of the commercial real estate markets and people would only sell if they had to, because no one would want to sell and pay 35 percent tax.”
“Section 1031 is like the 401k of real estate,” Wagner adds. “You’re able to grow into bigger, better properties when you do a 1031.” And it’s very much about jobs: real estate brokers make commissions, lawyers have fees, local communities get transfer taxes. And importantly, remodeling is frequently done before or after 1031 exchanges, providing jobs for people to paint, put on new roofs, put in new windows, upgrade electrical, and so on.
To lead the fight in Washington, D.C., the IPA turned to Daniel Cullen, a highly regarded tax attorney and leading expert on real estate taxation issues. Cullen is a partner with Baker McKenzie in Chicago and an IPA board member.
When Cullen speaks about taxes, people listen. He was tasked with explaining the nuts and bolts of tax law and what the proposed changes would do to commercial real estate and to IPA’s members. “I was honored that the IPA leadership asked me to lead the special task force on tax reform,” Cullen says. Cullen put his heart and soul into the effort, making several trips to Washington, D.C., last fall and authoring a white paper that impacted the final legislation.
While protecting the commercial real estate industry is a major part of the IPA’s mission, Cullen points out that, more broadly, it is the indirect or direct investment in real estate. “Our membership puts together a variety of different financial instruments to access non-correlated real estate offerings as part of their overall diversified portfolio,” he says. The proposed changes to the tax code would have unintentionally harmed the investors that go into these instruments that many IPA members create, manage or sell.
Get the Facts Before You Tax
The IPA got Cullen and Wagner several meaningful meetings with senior tax counsel within various important Senate and House offices. This included the office of representative Kevin Brady, chairman of both the U.S. Congress Joint Committee on Taxation and the House Committee on Ways and Means.
Cullen sat down and showed them how Section 1031 is special because inherent in our tax system is a belief that continuity of investment is paramount to having a fair tax system. And Section 1031 like-kind exchanges provide investors that continuity of investment.
But there were major hurdles. As Cullen met with people, the prevailing thought in the Committee on Ways and Means was that if the new tax laws allowed businesses to immediately write off (or “expense”) the cost of new investments in depreciable assets (called the immediate expensing provision), there would be no need to keep Section 1031 like-kind exchanges.
Cullen explained to them how this would be very problematic. After he met with counsel of the House Ways and Means Committee, they were so impressed with his presentation that they asked him to write a white paper that outlined the distinctions between Section 1031 and immediate expensing, something the committee had not fully considered.
He showed them that in real estate deals, immediate expensing was not the same as like-kind exchanges. For example, you cannot expense land, and of course land is a deal component in many real estate projects. “So you’re going to have a huge portion of the deal that won’t be re-invested,” Cullen says.
Also, many real estate deal structures existing today use Section 1031 like-kind exchanges contractually, and immediate expensing would not help in these transactions. For example, when REITs buy real estate with their equity, they can issue operating partnership units in exchange for the property as part of what is called an UPREIT transaction. “Because of Section 1031, REITs are able to use equity to buy property,” Cullen says. “Absent 1031, that would be very much stymied and you’d have this chilling in the market.”
Smaller mom-and-pop businesses would also be hurt by the elimination of 1031, and that was an important part of the argument. “The direct impact on several family businesses, particularly farming families where so much of their wealth is tied up in land, couldn’t be offset by immediate expensing,” Cullen says. “If they wanted to sell one piece of land and invest in another piece of land, immediate expensing would have been no use to them.”
Needless to say, the tax reform writers had not thought out these things. “There was an honest but true, logical disconnect, and we helped correct that,” Cullen says. “This is where we added value and delivered a meaningful result when you saw the final legislation,” he adds.
What does Cullen think made the biggest impact in his meetings? “When we talked about the greater need for Section 1031 when contrasting it to immediate expensing, and the types of transactions that wouldn’t be covered by immediate expensing, I felt we got their attention,” Cullen says.
“We were able to speak with the individuals who had the actual pens in their hands crafting the legislation, and that was a powerful experience,” Cullen remembers. “It will definitely be one of the memories of my career when I retire some day.”
“There’s a reason why 1031 has been part of the tax code for almost 100 years,” Wagner adds. “The forces in Congress initially wanted to get rid of 1031 to raise revenue, but once they started getting into it, they realized that 1031 is really the sparkplug, the engine of our economy.” Still, no one knew the educational and lobbying efforts had been successful until the legislation actually came out. “There were some long nights,” he says.
Politics can indeed make strange bedfellows, and the coalition to preserve Section 1031 included both conservative business people and ardent conservationists — not normally natural allies. That’s a broad coalition. As Wagner explains, conservation groups go to farmers who have land along a river, such as the Mississippi River. The conservationists offer to buy some land to put a buffer zone between the pesticide runoff from the farm and the river or tributary nearby. Then the conservation groups can clean the water before it runs into the river.
The farmer cannot sell the land if he has to pay 35 percent tax — he could never afford that. But the farmer can “1031 it” into a conservation easement. “Farmers are dirt rich and cash poor,” Wagner explains. They love 1031 because it is how they can monetize their property. And conservationists love it because they are able to protect the land. Without 1031, these transactions would never happen. Explaining such nuances helped convince Congress to keep the provision.
Saving the Net Interest Expense Deduction
Real estate deals are usually done with leverage, and investors count on the ability to deduct the interest. But the original tax reform proposal recommended getting rid of this interest deduction. Just like with Section 1031, tax reformers saw a possible quick way to save money. “When you’re in a vacuum and you see things that can bring numbers down, it’s easy to say, let’s get rid of this,” Wagner notes.
But the coalition was able to show Congress and the tax writers that the impact in real life would be far different, negatively impacting commercial real estate and the economy. “It would be like taking the blood vessels out of commercial real estate deals,” Wagner says.
“We were able to explain to them that real estate can be several different things depending on the asset class and where it is currently situated in its life cycle,” Cullen says. But for many, real estate is a fixed-income play — long-term appreciation and value-hold. Billions and billions of dollars worth of big projects have been put together where they price the project to include an inherent ability to use leverage and deduct a portion of that leverage.
To eliminate the net interest expense deduction for real estate could have created a disaster similar to what happened after the 1986 tax reform law, which many believe contributed mightily to the decline of the real estate industry that decade.
No one wanted that. “If the goal was to stimulate the economy and create jobs, I thought this was something that was simply contrary to their goal and wasn’t in their best interests,” Cullen says.
Cullen made his points in personal meetings, walking through publicly available information about deal case studies. He was able to show that whether it was major real estate funds, where there is pricing not only for institutional investors but also retail investors investing directly through private placement and REITs, if you eliminate that interest deduction, their net present value and future IRR would both take hits — it would immediately negatively impact pricing.
“They took that under consideration, and I’m glad they landed where they did,” Cullen says. The tax reform writers ultimately agreed with Cullen’s assessment, preserving net interest expense deductions for real estate.
While the IPA focused on 1031 and interest deduction, it also lent support to Nareit to lobby for the passage of reform legislation supporting lower taxes for “pass through” income, which is money earned by real estate partnerships, REITs and other structures where the income is passed through to its owner and taxed at the individual rate. This effort was also successful.
Did having a commercial real estate mogul as president of the United States help the cause? It certainly did not hurt, but Cullen points out that at no time did he feel the White House was taking an undue focus on the real estate industry, but rather was focused on stimulating the economy and the creation of jobs. “I don’t think future administrations are going to view our arguments differently,” Cullen says. “I think our arguments really had substance behind them and they weren’t wed to any particular partisan position, which may be why we were ultimately successful,” he concludes.
The Tortoise and the Hare
The IPA was one of many groups that fought for commercial real estate during tax reform. “There was a coalition that truly came together and fought the good fight,” Cullen says. “The IPA kept a fire under the feet of both its membership and its audience. It took its game to another level and that was a great feeling and personally rewarding.”
Commercial real estate is IPA’s commodity, Wagner notes. “Whatever would hurt commercial real estate would impact all our investors,” he says. “Our whole purpose was to promote and promulgate good tax reform laws that help our investors. We were able to do that.”
It involved patiently educating people as well as lobbying them. “We weren’t the hare; we were the tortoise. And we won the race,” Wagner says.
“We fought day in and day out for an extended period of time,” Cullen adds. “We ended up prevailing on each of our key points and really delivered a successful result on behalf of our membership.”