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Addressing the Infill, Low-Income Housing Challenge with Private Capital & the 1031 Exchange Law

The “Holy Grail” of affordable housing is small-scale, infill, low-income-serving development located near vital public services, employment opportunities, essential retail (food, pharmacy, etc.), public transportation, and in locations where sufficient physical infrastructure exists to enable that development (water, sewer, power, and adequate roadway/traffic capacity).

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"Low-income housing" is defined as housing for those most in need; the poor and the disadvantaged among us, as opposed to "affordable housing," which now includes families making almost $200,000 per year.

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For every opportunity to develop one large, multifamily, housing project in suburban and ex-urban communities there are dozens of opportunities for these smaller, infill projects.

So, why aren’t those opportunities being realized?

First off, big, for-profit developers have no interest in these projects because they don’t fit their business model. At the same time, small local and regional developers who are interested are at a tremendous disadvantage (1) because of the dysfunctional way federal and state housing Low-Income Housing Tax Credit subsidies are allocated (which favors big developers and big projects) and (2) because they have far less access to debt financing and investment capital.

Since it remains axiomatic that neither nonprofit nor for-profit developers can build low-income housing without some type of financial subsidy and government subsidies and tax credits remain grossly inadequate to address the need, the lack of availability of private investment capital is the single biggest obstacle.

So, how can we flip the script and increase financing liquidity and private capital investment in low-income housing?

The 1031 exchange rule

A 1031 tax-deferred exchange is a provision in the U.S. tax code that allows real estate investors to sell real estate (“real property” as defined by the IRS; land, permanent structures, improvements, air rights, water rights, etc.) and defer tax on capital gains and depreciation recapture if the proceeds are reinvested in another property within a set time.

This tax-deferred method is a key driver of the real estate investment market. If the goal is to attract more private investment capital to develop small-scale, infill, low-income housing, we must be cognizant of this.

However, to take advantage of this tax deferral provision, the assets exchanged must be “like-kind” (real estate for real estate). Since exchanging a “market-rate” housing project for a “low-income” housing project of investment in new low-income housing development rarely makes financial sense and the statutory exchange time period is relatively short (45 days), 1031 exchanges are seldom used to purchase or develop low-income housing projects.

But is there an enormous opportunity here, hiding in plain sight?

A low-Income Housing, “non-like-kind” 1031 Exemption

A solution to the lack of private investment capital being committed to the development of low-income housing (as defined by HUD) could utilize the 1031 methodology.

Currently, 1031 exchange rules do not allow taxes on the proceeds from the sale or exchange of “personal property” to be deferred.

What if federal and state legislators allowed investors (an individual or legal entity such as a corporation, LLC, partnership, etc.) holding “personal property” to do a 1031, tax-deferred exchange of "non-like-kind" assets for real estate -- if and only if the funds are reinvested in the construction, renovation, or preservation of "low-income" housing units?

(Note: In the case of new development and renovation, this would require a longer period of time for the sale/exchange to be finalized and regulatory parameters such as minimum investment holding periods, etc. would need to be determined.)

Outcomes

It is likely that such a “non-like-kind” tax-deferred exchange provision would be a significant incentive to attract private investment for low-income and mixed-income/mixed-use affordable housing development, renovation, and preservation.

At present, there is considerable investment capital “locked up” in “personal property” that could take advantage of this proposal.

It is not hard to imagine a conservative financial manager advising his clients -- who are holding volatile personal assets (common stock, stock options, warrants, bonds, commodities, crypto, etc.) or difficult-to-value or illiquid personal assets (art, jewelry, collectibles, automobiles, boats, airplanes, etc.... rocket ships?) – to diversify their portfolio by allocating the values of some of those holdings into real estate -- and in this case, real estate investments with project revenues derived from federal Section 8 housing vouchers, which have tenant waiting lists at local housing agencies that are years long because of the lack of available, low-income housing units.

Real estate investments are unique in that real estate’s value and appreciation are historically more stable than most other investments, returns on investment are more predictable, and it offers financial benefits generally unavailable for personal property assets.

Real estate is also income-producing, while simultaneously providing considerable tax benefits (sheltered income) from depreciation and operating expense write-offs, and it benefits from the robust financial leverage of construction loans and permanent financing (debt that is paid off by the tenants).

Fiscal Impacts and Tax Consequences

In California, real estate investors currently pay up to 13% in state income tax. And the sale of real estate is taxed the same as ordinary income. In 2021, California received $25B in tax receipts associated with capital gains. That equates to $190 billion in potential investment capital at California’s 13% rate.

Although this new provision would decrease capital gains tax receipts, that decrease would be more than offset by the increase in revenues/income/property taxes/sales tax receipts and fees due to the “economic multiplier effect” resulting from new real estate development and household and business formation.

Finally, California does not currently provide a long-term, capital gains tax rate for real estate investors. This is incredibly shortsighted.

As an extra incentive to invest in the development, renovation, and preservation of low-income housing, the state should consider creating a special, long-term capital gains tax rate (e.g., 5%) for investors engaged in these new “non-like-kind,” low-income housing investment transactions for ancillary property purchases and sales that are part of “assemblages” or are otherwise physically essential to the financial feasibility of low-income development or renovation projects.

As complex as this may sound to those who have never invested in real estate, the good news is that just as it happened when Low-Income Housing Tax Credits were created and new tax credit syndication and brokerage entities merged to facilitate the sale and purchases of those tax credits by third-parties, in this situation, once again, brokers and facilitators of these "non-like-kind" 1031 transactions will quickly emerge to ensure liquidity.

There is actually some precedent for the mechanics of this in terms of being able to exchange "physical" real estate assets for "financial" real estate assets by using what is called an UPREIT (umbrella partnership real estate investment trust), also commonly known as the 721 exchange.

This new tax-deferred exchange proposal simply substitutes "non-like kind" assets of all kinds for "physical" real estate assets and/or for investment vehicles (ETFs, mutual funds, private equity funds, etc.) that invest in "physical" real estate assets, but only if those are invested in the preservation, renovation, or development of low-income housing.

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