Like-kind exchanges long history of tax deferment
Established in 1921, like-kind exchanges allow taxpayers to defer paying taxes on certain types of assets when they use those earnings to invest in another, similar asset. An interesting point about these exchanges is that they can be done repeatedly, provided the transaction involves a similar type of property. For this reason, the like-kind exchange is widely used in certain industries on assets such as real estate, machinery for farming and mining, and equipment such as trucks and cars. Commercial real estate is one of those industries, but the appeal for car rental companies, for example, is easily seen. Additionally, under section 1031, investors don’t have to pay taxes until they realize profits from their transaction – meaning, they’ve “cashed out”. The structure eliminates a potential barrier to investment, which can promote efficient allocation of capital resources.
Is the real estate mogul advocating elimination of 1031?
It’s no secret how Donald Trump made his money. So, as his administration looks to fulfill on their campaign promises of tax reform, it seems unusual that 1031 exchanges would be on the chopping block. However, increasing pressure to reduce interest rates and identify new revenue offsets means that tax reform committees are looking closely at everything – including that section of the tax code.
Much of the interest in examining 1031 began in 2014 when the Congressional Joint Committee on Taxation (JCT) presented evidence that over 10 years, a nearly $40 billion tax-revenue gain could be realized through the repeal of 1031. Seeing this opportunity, President Obama proposed a $1 million cap on 1031 tax savings and then, two years later, proposed further restrictions which would completely eliminate exchanges of collectibles, artwork and other personal property which are allowed under the law.
The current President’s refusal to provide his own tax returns as well as the disclosure of a $916 million tax loss he claimed in 1995, that offset nearly two decades of his income taxes, created new interest among the media and the outgoing party in shining a light on tax provisions alleged to serve only the wealthy or special interest groups. Among these, was 1031 like-kind exchanges.
Despite the scrutiny of 1031, others disagree with the convictions of the former administration and the assertions of the media. Suzanne Goldstein Baker, Executive Vice President and General Counsel of Investment Property Exchange Services, Inc. in her article on 1031taxreform.com writes, “It is imperative that 1031 be preserved for exchanges of land and other assets that are not covered by immediate expensing. Of particular concern to real estate owners is the potential combined whammy of the inability to expense land value with the elimination of the business interest expense deduction.”
Accounting powerhouse Ernst & Young agrees with Baker’s sentiments. In their study, Economic Impact of Repealing Like-Kind Exchange Rules, the company identifies multiple problems with the repeal of 1031. They go so far as to say that repeal is actually at odds with the goal of tax reform and would result in less federal revenue, a shrinking of the U.S. economy by up to $13.1 billion annually, less overall investment and would create a generally negative impact on the overall economy, with an unfair concentration in certain industries.
The National Association of Realtors is another non-supporter of 1031 repeal. In their own study, they found that 63% of Realtors participated in a 1031 exchange and 40% indicated that transactions would not have occurred in the absence of the tax provision, and 56% said even if the project would have occurred it likely would have been smaller in scale.
The future of like-exchanges
As it stands, section 1031 says that if you sell a property, but buy a replacement property of the same value or more within a given time period, you are able to defer the capital gains tax until you sell the replacement property.
One of things mostly likely to lend some influence to the like-exchange rules is The House Blueprint for tax reform. This plan proposes full and immediate expensing for business investment in buildings and equipment, although it does not include land. Some argue that this makes Section 1031 unnecessary, though others argue that 1031 should be continued for land.
Some things are certain. Like-exchanges present a real benefit for real estate investors. It’s also nearly as certain, that with a Republican congress and a President who has built his fortune through real estate investment, and relied on those benefits, that 1031 exchanges will be here to stay.