Proposed Tax Changes Could Eliminate the 1031 Exchange

After tabling the plan to repeal and replace the Affordable Care Act (also known as Obamacare), the legislative focus in Washington appears to be shifting back to tax reform. While the details are still unknown, both the White House and the Republican leadership in Congress have given some indication of desired changes to current tax policies. As these changes would affect taxes for both individuals and entities, there is a high likelihood that the private placement market will be affected. In particular, the reorganization of the individual brackets, lowering of the corporate tax rate, and possible changes to the 1031 exchange could lead to a significant shift in the private placement marketplace.

Changes to the Individual Brackets

President Trump has proposed decreasing the number of brackets for individual payers—something not likely to have a major effect on private placement investments. Under the current US Tax system, there are seven individual brackets. The president, along with his allies in Congress, propose decreasing this number to three brackets with rates of 10%, 25% and 35% respectively. For top-earners, this would drop their income tax rates from effectively 40% to around 35%, allowing them to put that money to work in other ways. Additionally, the president has proposed eliminating the Alternative Minimum Tax, which also significantly affects top-earners. While it is possible that these benefits could be counter-balanced with changes to itemized deductions and the failure to eliminate the 3.8% net income investment tax tied to the Affordable Care Act, it is likely that top-earners, many of whom are accredited investors, will have more capital to deploy into the private and public markets.

Lowering of the Corporate Tax Rate

Congressional Republicans and the White House have both proposed lowering the US corporate tax rate. In March, the Trump Administration proposed moving the corporate tax rate from 35% to 15%. Additionally, the Republican leadership in Congress has proposed establishing a new 25% rate for certain pass-through business income. Both of these changes could have potentially beneficial effects on the market in general, and private markets in particular. Cutting the corporate rate, one of the highest in the world, by more than 50% is predicted to have several effects on the market. One such effect would be a likely increase in earnings per share in the public markets. This same benefit would apply to investors in the private markets as well, as dividends would likely trend higher for investors in private entities. Additionally, certain industries that bear more of a tax burden, such as utilities, telecom services, and industrials, will see this burden lightened. This may lead to these industries garnering more interest from investors. 

Creating a new 25% for certain pass-through entities would likewise benefit the private securities market. Currently income from pass-through entities, such as partnerships or LLCs, is taxed at the partner level based on his or her distributive share. This is based on how much of the partnership each partner owns. Partnership income is generally taxed as ordinary income, which means for an individual in the highest tax bracket, their partnership income could be taxed at levels as high as approximately 40%. Lowering the maximum rate on income from pass-through entities to 25% would add incentive for individuals to place their excess capital into these already lucrative investment vehicles.

Changes to Section 1031

One may wonder how the President and Congressional Leadership intend to pay for these tax cuts. Both the White House and Congress have proposed eliminating the 1031 exchange provision as one of the several ways to account for tax cuts. The 1031 exchange provision of the US Tax Code allows a taxpayer to defer recognizing his income on the sale of investment property. One industry in particular that relies heavily upon IRC Code  Section 1031 is the commercial real estate industry. To accomplish the 1031 exchange, investors generally sell their current real estate and invest those funds into an offering that is structured to accept 1031 exchange funds. These offerings are most commonly structured as offerings into Delaware Statutory Trusts, or DSTs. Based on our research into Form D filings from January 1, 2017 to June 30, 2017, over a billion dollars has been raised through DSTs so far this year. Based on that number, as well as historical data, it is clear that Section 1031 plays a large part in private commercial real estate investment markets. With that in mind, a repeal of Section 1031 or limitation of the amount of income that can be deferred would dramatically affect the commercial real estate investment market. Most likely such a limitation would hamstring this market for some time.

Until the White House and Congress present their actual tax reform proposals, the private placement market remains uncertain of any change’s potential effects. From what has been disclosed, it is clear that changes such as simplifying the individual brackets, adjusting the corporate tax rate, and the potential limitation of the use of Section 1031 will have ripple effects in the private placement market as a whole. For now, we and the rest of the country wait patiently for a more fully baked plan from Washington.

Neither the author nor WealthForge are tax experts. The author bases this analysis on his experience in the private placement markets. The author, WealthForge and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.