How a Tax Benefit for Developers Could Backfire in the Pandemic

“This replacement property now has tenants who are no longer paying rent — WeWork-type tenants, restaurants, tenants who may be going out of business,” Ms. Kraus said. “It’s a mess that you can’t clean up quickly.”

Because some properties no longer make economic sense to buy, she has advised her clients to invoke a separate clause that lets parties in an exchange get a 120-day extension if a disaster occurs during the process.

“They have nothing to lose,” she said. “How much worse can it get?”

Hanging over all of these exchanges are incredibly high taxes if they are not completed. An investor who did not find a replacement property would be have to pay a federal capital gains tax of 15 percent to 20 percent, said Mr. Madden of Kay Properties. For example, an investor could lose a $6 million benefit on the capital gains tax of the sale of a building that nets $30 million.

But the investor would also be subject to the Medicare surtax of 3.8 percent, state capital gains taxes of up to 13.3 percent and a depreciation recapture tax of 25 percent for depreciating the value of the building for annual income tax payments, he said.

The benefit — or downside — is often greater with like-kind exchanges than without. The investor can continue flipping the investment tax free until death, when the entire portfolio will be valued at that point. This so-called step-up in basis wipes out decades of embedded capital gains taxes that were never paid. The arrangement benefits the heirs, although the estate taxes could still be owed.

Paying tax is a regular occurrence for investors in most other public and private markets, from stocks and bonds to hedge fund gains, but it’s a rarity in an industry that benefits from generous tax abatements, deductions, deferrals and reductions.

This time around, however, paying the capital gains tax now may be the better option because falling property values may erase any tax advantage from the exchange.

“Since the market did switch, we’ve seen a few 1031 buyers say, ‘I’m just going to pay the tax,’” Mr. Stein said. “These were buyers who never would have paid tax. I have one friend who said he’s scared that he doesn’t have enough cash.”

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