IRC Section 1031 Exchange – We Need It
IRC Section 1031 Exchanges serve as one of the most useful tools taxpayers can implement when investing in real property. A 1031 like-kind exchange allows taxpayers holding property for investment purposes to potentially defer all taxes that they would otherwise have had to pay at the time of the sale. This means that a taxpayer can sell their appreciated real estate, use the money from their gain to purchase other investment real estate, and have the exchange not be immediately taxable. Without it, a seller has to pay taxes at the federal and state levels and also on prior depreciation that was utilized to defer taxes on the income from the property.
The Section 1031 exchange has become a useful strategy not only for major investment firms but for casual investors as well. As tax rates rise, all investors look for strategies to reduce or defer taxes, and the 1031 Exchange is one of the most basic yet valuable tax deferrals around, making it essential to protect.
The reasoning behind the deferral of like-kind exchanges is fairly academic. According to our tax code, in order for something to be recognized as a gain or loss, a taxpayer must “realize” it first. There are various “non-recognition” rules that exist which aid a taxpayer who is continuing an investment. The premise is that it makes sense to defer the recognition of any gain or loss realized, until the taxpayer truly ends the investment. In the case of like-kind exchanges, the exchange of an asset for a similar asset represents a continuing investment, or a shift in investment, that cannot be taxed until the investment is complete. Usually the deferment of these taxes is simply an issue of timing. It is not will the capital gains tax be taken into account? But rather, when will it be? Some investors however are able to indefinitely defer these taxes.
Tax deferral transactions like these led the Joint Committee on Taxation (JCT) to investigate lost tax revenue due to Section 1031. Traditionally, the JCT had estimated tax losses due to Section 1031 at $10-15 billion over a ten year period. In 2014 however, the JCT progressively increased this estimate until they reached an approximation of $98.6 billion in lost revenue. Recently, Congress has been looking to lower corporate taxes from 35% to 25%. One way to accomplish this is through revenue offsets, or in other words, paying for tax reform by eliminating existing tax benefits instead of increasing tax rates. 1031s could be in danger, as they have been brought into this discussion of potential revenue offsets.
In addition, there is a history of proposed legislation and policies that have been against 1031 Exchanges. In fact, the outright repeal of IRC Section 1031 has been brought up before on separate occasions. The Tax Reform Act of 2014 (HB1) and the Senate Finance Committee’s “Discussion Draft: Cost Recovery and Accounting” both called for the repeal of like-kind exchanges. Even though HB1 expired, talk continues to persist regarding the outright repeal of 1031 Exchanges. Furthermore, there have been several discussions on capping the annual gain deferral at $1 Million. The US Treasury’s 2015 budget was one instance of this, as it explicitly proposed placing a limit on real property exchanges to $1 million annual gain deferral.
In fact, President Obama had advocated several times to limit 1031 deferral at $1 million. He even looked to completely eliminate exchanges on collectibles, artwork and personal property. These approaches all seem to stem from the underlying feeling that participants in 1031 Exchanges are not paying their fair share of taxes.
Statistically, here are some data that speak to how significant 1031 Exchanges are to the U.S. economy. According to the National Association of Realtors, 63% of realtors participated in a 1031 exchange within the past four years. Out of this percentage, 40% said that without section 1031, the transaction would not have occurred. Additionally, 56% said that without the tax deferral their project/development would have been much smaller in scale. Ernst and Young, one of the “Big Four” accounting firms, even did a macroeconomic study on the impacts of the repeal of the Section 1031 Exchange. Their report declared that repeal would overall shrink our economy and discourage investment. In fact, they estimated a reduction in the overall GDP of $61-131 billion over ten years.
Repeal of 1031 Exchanges could discourage business investment to the detriment of the overall economy and could increase the cost of capital. Repeal could subject businesses to higher tax burdens, larger holding periods, and a greater reliance on debt financing. Considering that the deferral encourages investment and reinvestment in U.S. assets, without it, overall reinvestment could be stifled.