The Near Death of the 1031 Exchange
Section 1031 of the Internal Revenue Code (IRC) is one of the more useful tools available to U.S. taxpayers. Section 1031 allows taxpayers to defer recognition of capital gains when they “exchange” their property for other property of a like-kind. Hence, the name for a transaction under that section of the tax code is “1031 exchange” or a like-kind exchange by professionals in the 1031 exchange industry. Ordinarily, an investor cashing out of his or her investment through a sale incurs an immediate tax liability. But with a 1031 exchange, there is a deferral of this tax liability. That allows additional monies for investment in more expensive, potentially better-performing, investment property.
The History Behind Sec. 1031
Section 1031 has a long history. The provision was created nearly 100 years ago. Today it is frequently invoked by investors who seek to maximize the return on their investment capital. The rationale for Section 1031 is twofold. First, the intent of the section is to promote economic activity in general. Second, the section means to avoid unfair taxation by not recognizing merely “paper”. In its earliest stages, a typical use of Section 1031 was to clarify property lines between neighboring farmers; gradually, however, over time, more and more investors began using this section specifically as a wealth creation device. Thousands of 1031 exchanges happen every year in the U.S. They are performed by investors seeking to defer gains and acquire more productive investment properties.
Just Another Loophole?
The fate of the 1031 exchange recently came up as Congress made its latest tax code revisions. Some people contended that the 1031 exchange has lost its connection to its original purpose. They argue that it has become merely a “loophole” in need of either modification or elimination. On the other end of the spectrum, others argued that Section 1031 contributes to the national economy. It does so, they state, by promoting transactional activity and increasing wealth among investors. Congress considered multiple avenues, ultimately preserving the 1031 exchange for real estte. Those for personal property exchanges were, however, eliminated. In this article, we will summarize the arguments on both sides of this exciting debate. We’ll then briefly discuss some of the trends in the current 1031 exchange industry.
Naysayers: Close the Loophole
Arguments against the 1031 exchange tend to emphasize the continually worsening financial condition of the federal government, or they highlight the evolution of 1031 away from its alleged true purpose. Under Section 1031, taxpayers can defer capital gain taxes for as long as they hold their property. This can result in the deferral of very large tax liabilities. If a corporation, for example, sells real estate with a value of $100 million and has substantial gains, it’s clear that the federal government is missing out on a large chunk of income when the corporation performs a 1031 exchange in conjunction with such a sale. Given the financial condition of the government, there may be an argument that the closing of 1031’s provisions is necessary to help the government’s pocketbook.
Those favoring a shutdown or curtailment of Section 1031 sometimes point to the fact that exchange transactions look very dissimilar to early 1031 exchanges. When like-kind exchanges were first introduced in 1921, they were not performed as frequently. At that time, the purpose of Section 1031 exchanges, then known as Section 112 transactions, was not solely wealth maximization. Opponents of 1031 thus reasonably argued that the current 1031 exchange industry is out of step with its original “purpose”. Accordingly, they conclude, reform is necessary.
Yay-sayers: Preserve the Like-Kind 1031 Exchange
Supporters of Section 1031 counter by emphasizing the twin principles on which the section is based. Supporters highlight the fact that 1031 exchanges promote related economic activity. They do so by driving construction services, title insurance services, broker services and similar activity. Eliminating the 1031 exchange would have the unfortunate consequence of reducing these related activities by a significant margin. It would also drag down the general health of the U.S. economy.
Section 1031 supporters can also claim that this section promotes fairer taxation. If an investor conducts a 1031 exchange following all applicable rules, technically they haven’t “recognized” whatever underlying gains they have. Therefore, eliminating 1031 would seem to impose an unfair layer of taxation on investors. The U.S. economy will likely see a significant reduction in real estate investment if this provision is removed.
Finally, there’s a defensible argument that eliminating like-kind exchanges won’t significantly impact the national pocketbook in the long-term. An academic study jointly conducted by Professors David C. Ling (University of Florida) and Milena Petrova (Syracuse University), found that a high percentage of like-kind exchanges, perhaps 88% of them, result in taxable sales. Removing 1031 exchanges entirely would simply have the undesirable effects of preventing taxable sales and also reducing other related economic activities.
The Resolution: Elimination of Personal Property Exchanges
Lawmakers ultimately chose a middle ground and agreed to eliminate personal property exchanges exclusively from the code. Although like-kind exchanges of real property constitute the bulk of 1031 exchange activity (in terms of overall value), the impact of this change will be significant as many individuals and corporate entities traditionally utilized personal property exchanges on a regular basis. For instance, many companies often used personal property exchanges to exchange company-owned vehicles – such as cars and jets – but now they will no longer have this option.
Call Us For Assistance!
These recent revisions have given Section 1031 an unusually significant amount of attention. It’s reasonable to assume that we’ll see more about Section 103 in the media in the future. There are myriad potential issues which can arise with a 1031 exchange. Leasehold affiliate exchanges, related parties, etc. are often encountered. Therefore, there’s a high probability that we’ll discuss Section 1031 again soon. Our New York tax attorneys have lots of experience navigating the complexities of the 1031 exchange. We’re happy to assist you with these transactions. Like-kind exchanges can get a bit tricky. Based on that, we think it’s wise to consult with a skilled and experienced tax attorney. Contact a NYC tax attorney online or at Mackay, Caswell & Callahan, P.C. by calling 1-844-MCC-4Tax to learn more.
Image credit: Steve Liefschultz