By Scott Saunders
Like-kind exchanges have been a vital part of the Internal Revenue Code under Section 1031 since 1921. A 1031 exchange allows an investor to defer the recognition of capital gains when exchanging one appreciated investment property (the “relinquished property”) for another “like-kind” investment property (the “replacement property”).
Most commercial 1031 exchanges today are orchestrated transactions in which an investor uses a qualified intermediary (QI) to facilitate the sale of the relinquished property to one party and the purchase of the replacement property from another party. The capital gain inherent in the relinquished party is not taxed upon its transfer.
However, since the basis of the relinquished property becomes the basis of the replacement property, the capital gains tax is not eliminated, it is merely deferred until the property is sold, or exchanged for non-like-kind property.
Contrary to popular myth, Section 1031 is not a loophole or a tax savings vehicle. As mentioned above, the capital gains tax is not avoided — it is merely deferred. This outcome is based on sound tax policy.
The essential logic is that the investor, in exchanging one appreciated property for another like-kind property, has not realized the gain inherent in the relinquished property. The investor has merely changed the form of his investment.
Since the basis of the relinquished property becomes the basis of the replacement property, the built-in gain is still there; it will be taxed later when the investor actually realizes the gain by selling the property for cash.
Section 1031 accurately reflects the economic reality of investment continuity in which no profit is realized, thus there is no premise for taxation.
Over time, 1031 exchanges have become an important fixture in the economy and the real estate industry. This is particularly true in the commercial market, where approximately 25 percent of all transactions involve an exchange on either the sale or purchase.
What’s more, 1031 exchanges allow investors to freely adjust their investments among like-kind properties, allowing for a more efficient allocation of capital.
Exchanges allow investors and business owners to change geographic locations, consolidate, diversify and redeploy into different types of investment assets. This commercial activity creates jobs, financial opportunities and provides a valuable stimulus to many economic sectors.
Section 1031 Under Siege
There are currently three different proposals that the federal government is weighing, which would significantly alter Section 1031:
- Former Sen. Max Baucus (D-Montana), who became U.S. ambassador to China earlier this year, released a draft proposal when he was chairman of the Senate Finance Committee that would potentially eliminate 1031 exchanges. His proposal, which is still before the Senate Finance Committee for discussion, contains other provisions unfavorable to real estate investments, including lengthening depreciation schedules for commercial and residential properties from 39 and 27.5 years, respectively, to 43 years for both and characterizing gains from real estate sales as ordinary income, instead of capital gain.
- U.S. Rep Dave Camp (R-Michigan), chairman of the House Ways and Means Committee, has released a proposed tax bill eliminating all Section 1031 exchanges beginning Jan. 1, 2015.
- President Obama, in his 2015 budget proposal, proposes limiting the amount of capital gains deferred in a 1031 exchange to $1 million (indexed for inflation) per taxpayer per taxable year, beginning Jan. 1, 2015.
Law of Unintended Consequences
The motivation behind these proposals is to increase tax revenue. The effect is to target the real estate industry, particularly real estate investors and business owners. Other professionals involved in commercial transactions would also be negatively affected.
The above proposals appear to be based on calculations that do not consider that if investors are unable to defer gains by using Section 1031, many prospective sellers will simply hold on to their properties and will not sell at all.
Most of the projected additional tax revenue will never materialize because investors with significant gains will simply hold onto their property rather than face a sizeable tax consequence. The result would be a significant decrease in transactional activity, and a significant reduction in the inventory of available investment properties.
Potential Ripple Effects
This would result not only in reduced commissions for commercial brokers, but would also have a negative impact on jobs across a wide array of ancillary services that are also involved in exchange transactions.
Banks and commercial lenders would see reduced activity, as would title companies, escrow agents, appraisers, environmental companies, and many other services typically involved in commercial real estate transactions.
Eliminating Section 1031 would have a negative impact that would extend far beyond the real estate market, into the overall national economy. It is foreseeable that the elimination of Section 1031 would result in a decrease in property values as investment properties become more illiquid.
This loss of equity in real estate would result in less spending and investment in the economy overall, which would ultimately result in lost jobs, increased unemployment and billions of lost revenue each year for the national economy.
This is not the first time the government has tried to reduce the tax deferral benefits of Section 1031. In fact, there have been numerous attempts to limit exchanges in the past. One proposal was to create a much more narrow definition of like-kind property. This would have had a significant damper on real estate activity.
The key to preserving 1031 exchange tax deferral is to educate legislators on the economic benefits of exchanging. Once government representatives really understand that exchanges actually promote transactional activity, thereby creating jobs and other taxable income that helps small and mid-sized business prosper, they realize Section 1031 is a vital part of the U.S. economy’s economic engine.
Exchanges encourage property owners and business owners to preserve and manage cash flow, thus encouraging U.S. business to reinvest domestically rather than offshoring business activity. Exchanges also help foster higher property values which increases the property tax base.
1031 Exchange Supporters Unite
In light of these potentially dire consequences resulting from the elimination of Section 1031, the Federation of Exchange Accommodators (FEA) continues to educate legislators about the essential economic value of 1031 exchanges.
The FEA and roughly 42 industry groups have filed comments with the Senate Finance Committee advocating the retention of 1031 exchanges, and they continue to work to enlighten Congress on the job-creating aspects of 1031 exchanges.
What can you do to help preserve Section 1031 exchanges? Contact your representatives in Congress to express support for Section 1031 in its current form, and the economic activity and job-stimulating aspects of this powerful tax code section.
You should also call your local commercial association and have them contact the FEA (www.1031.org) to find out how it can increase the effectiveness of education efforts to support the continued availability of 1031 exchanges.
Scott R. Saunders is a senior vice president of Roseville, Calif.-based Asset Preservation Inc., a national qualified intermediary and Stewart Title subsidiary. Questions regarding 1031 exchanges can be directed to him at scott@apiexchange.com or 888-531-1031.