Internal Revenue Code Section 1031 exchanges, more commonly known as “1031s” or “like-kind exchanges,” are a nearly century-old tax deferment mechanism that may be targeted for elimination or curtailment under several tax reform proposals being considered in Congress.
Using a 1031 exchange is simply a matter of timing and taxes: The taxes are delayed in order to make important investments happen in the interim. Specifically, a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property. This may include real estate, heavy equipment, conservation land and other investments.
{mosads}Importantly, the exchange provides tax deferment — it does not forgive the tax, but rather postpones the tax due until final disposition in order to encourage further investment.
Section 1031 of the code states, “No gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” The intent underlying 1031 exchanges is to provide for continual reinvestment and the resultant growth in the private economy that follows.
For example, when an asset such as medical equipment is sold, federal and state capital gains, combined with recaptured depreciation taxes, might equal more than 40 percent of the sales price. Rather than paying tax on the sale, the seller can choose to defer this by reinvesting the entirety of the sales proceeds via a like-kind exchange. 1031 thus acts as a reliable investment catalyst, one that otherwise would be lost once an investment is sold.
These exchanges help provide an economic stimulus for our nation. Removing that stimulus would cost our nation upwards of $8 billion annually, according to a 2015 study by the accounting firm Ernst & Young LLP (EY) titled, “Economic Impact of Repealing Like-Kind Exchange Rules.” EY also reports that if Section 1031 exchanges are eliminated, investment levels nationwide are expected to decline by $7 billion annually, while national income would fall by $1.4 billion annually.
Importantly, these figures are net of the tax revenue associated with ending like-kind exchange tax deferrals. In other words, with the repeal of Section 1031, the government may get immediate funds but the economy suffers the effect.
The EY study also determined that the elimination of Section 1031’s treatment of qualifying like-kind exchanges would increase the cost of capital, even with lower tax rates. It would also discourage business investment, which would obviously adversely impact the overall economy. Further, eliminating 1031 like-kind exchanges would subject individuals and businesses to a higher tax burden, resulting in longer holding periods, greater reliance on debt financing and less-productive deployment of capital in the economy.
An additional misconception regarding Section 1031 exchanges is that they are tax “loopholes” for the wealthy. The predecessor to Section 1031 was included with the U.S. original tax code because it made sense: It created a deferred process for exchanging (not selling) one valuable property for another without generating a federal tax. Again, taxes are paid once an investment is completed; the money is put to work in the economy and generates economic activity during the delay.
In regard specifically to real estate, a 2015 study by David Ling, Ph.D., a professor at the Warrington College of Business at the University of Florida, and assistant professor of finance Milena Petrova, Ph.D., at Syracuse University, concluded that commercial real estate prices would decline between 8-17 percent in markets with moderate taxes and between 22-27 percent in high-tax states and markets in the event that the tax deferral provided by Section 1031 was reduced or eliminated altogether.
According to the study, moreover, rental prices in these markets would increase significantly, as high as 38 percent in highly-taxed markets.
Section 1031 like-kind exchanges are anything but a tax avoidance loophole; they are a nearly pure form of economic stimulus, a provision of the tax code that acts to increase investment and stimulate economic activity. Even from the tax collector’s perspective, in the final analysis, like-kind exchanges result in loss of depreciation and an increase in local sales and property taxes. There is no apparent downside to redirecting tax revenues in the interim to increased construction activity and the creation of countless jobs.
This country is looking to expand economic activity and generate growth. Section 1031 is a vital part of our tax code that is misunderstood and needs protection. While well-crafted tax reform would be welcomed by our association and our membership, we must not throw out the baby with the bath water.
Section 1031 is a fair and thoughtful means to maintain private sector investment, which results in significant economic stimulus. Tax simplification and lower tax rates are certainly welcome, but this goal can be met without destroying aspects of the code that are actually helpful, fair and valuable, such as Section 1031.
John Harrison is the executive director and CEO of ADISA, the Alternative Direct Investment and Securities Association, the nation’s largest trade association representing the non-traded alternative investment space.
The views expressed by contributors are their own and not the views of The Hill.