Written by Jim Miller | Western Operations Exchange Counsel, IPX1031®
There has been a lot of talk about the need to reform our huge and complicated tax code. Like most things in life, the tax code is neither all good nor all bad. As much as we hate taxes, we like many of the things they pay for, such as public schools, highways and national parks.
What’s on Which Table?
Section 1031 is one of the good guys in the Internal Revenue Code. Nevertheless, in the effort to create tax reform, recent proposals have been made by the Senate Finance Committee, the House Ways & Means Committee and the U.S. Treasury (i.e. the Administration) to eliminate or limit §1031 like-kind exchanges:
The House’s draft Tax Reform Act of 2014 calls for repeal of §1031 effective January 1, 2015.
The Treasury’s proposed FY2015 Budget proposes to limit real property exchanges to $1 million annual gain deferral, but is silent about personal property exchanges.
The Senate Finance Committee’s Discussion Draft: Cost Recovery & Accounting proposes to repeal §1031, but leaves the door open for real property and intangible property exchanges, and suggests a potential modification of the like-kind standard to the narrower §1033 standard requiring that the properties be similar in service or use.
The Purpose of Tax Reform
The stated purposes of the current efforts at tax reform are to broaden the tax base; to reduce the corporate tax rate to 25%; and to achieve a simpler, fairer and flatter tax code that is more efficient and which results in greater financial growth, job creation, and a strengthened U.S. economy. Additionally, the reformed tax code would improve the ability of U.S. corporations to compete effectively in a global economy, and increase foreign investment in the United States.
While it is hard to quarrel with these laudable goals, it is equally important that Congress preserve existing incentives for investment in real estate, equipment, machinery and other assets used by businesses to spur economic growth and productivity. It is incumbent upon us, the taxpayers and voters, to let Congress know that Americans want these desirable goals to be achieved without creating unintended consequences of unfairness, economic stagnation and job loss.
The Mythology of Tax Reform
The sound bites justifying elimination or limitation of like-kind exchanges are full of misconceptions:
- Myth: Significant revenue will be raised,
- Myth: §1031 is an unfair tax loophole for large corporations and wealthy individuals,
- Myth: §1031 is an abusive tax avoidance scheme,
- Myth: §1031 is problematic for the IRS and taxpayers, lacking a definition for “like-kind,” and
- Myth: The current nature of exchanges was not contemplated in 1921.
While it is certainly plausible that nobody thought about exchanging cell phone towers and television broadcast spectrums in 1921, these justifications are not valid. When the impacts of depreciation, the estate tax, and the economic stimulus generated by like-kind exchanges are considered, it is clear that elimination or limitation of §1031 would result in:
- Reduction in U.S. real estate values
- Economic stagnation
- Job loss across a myriad of industries
- No additional revenue to the U.S. Treasury
- No improvement to the tax code
It is not likely that tax reform will occur in 2014, and it may be several years before a tax bill is filed, but it is important that Congress be made aware that the sound bites are wrong. The REALTORS® Land Institute (RLI), along with the Federation of Exchange Accommodators and more than 40 other industry associations have provided comments to Washington that these proposals are ill-informed and will do great harm to the economy. The last major tax reform bill was passed in 1986. A serious recession in the real estate market ensued. We are working to prevent history from repeating itself.
Myth Busting: §1031 Provides a Powerful Stimulus to the U.S. Economy
§1031 contributes to the velocity of the economy, permitting efficient use of capital, encouraging U.S. businesses to reinvest in domestic operations, and promoting job growth in the United States. The tax benefits stimulate the economy by encouraging transactional activity. Owners of real estate, machinery, equipment, trucks, railcars, marine vessels and other business-use or investment assets are encouraged to dispose of inefficient assets and replace those assets with improved, more productive and better located assets. More transactions equate to more jobs and taxable wages in the real estate, title insurance, construction, financial service, equipment leasing, manufacturing, after-market alteration and installation industries.
No significant revenue will be raised by eliminating or limiting §1031 exchanges. Without the tax deferral incentive, many transactions will be delayed or foregone because taxpayers do not have the additional capital necessary to pay the increased cost of new property plus the capital gains or recapture tax on the sale of the old property. Fewer transactions ultimately result in fewer jobs not only in the industries stimulated by §1031 exchanges, but also at factories, restaurants, recreational, hospitality, tourism and other local small businesses that generate revenue from the after tax dollars of employed workers.
§1031 is an important driver of real estate transactions. We estimate that nationally, approximately 25% of commercial real estate sale and purchase transactions involve §1031 exchanges. In some parts of the country, the estimate is even higher. Farmers and ranchers also use like-kind exchanges to improve and expand operations, and to trade out of environmentally sensitive land into acreage more suitable for productive agricultural use. Loss of §1031 would cause stagnation in real estate markets, resulting in loss of property values, net worth and jobs.
§1031 is not an unfair tax loophole for large corporations and the wealthy. Rather, it is one of the few tax incentives available to and regularly used by taxpayers of all sizes, including small and mid-sized businesses, farmers, ranchers and other middle-class individuals.
§1031 is not an abusive tax avoidance scheme. The tax does not go away; it is only temporarily deferred. Tax will be paid either 1) upon sale of the replacement asset, or 2) incrementally, through increased income tax due to foregone depreciation, or 3) by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate double the capital gains tax rate. For every dollar of gain that is deferred through an exchange, there is an equal dollar of depreciation that cannot be taken on the replacement asset. This loss of depreciation results in increased income taxes. At the end of the depreciation schedule, the impact of §1031 is actually revenue neutral.
There are clear rules and definitions for §1031, making the use relatively easy and widespread. Qualified Intermediaries simplify the process, providing information and necessary documentation. Further, Qualified Intermediaries promote technical compliance with the tax rules, yielding a free benefit to the IRS. The rules for §1031 and definitions of “like-kind” are well understood.
The tax policy behind §1031 has not changed since its inception in 1921. Section 1031 is predicated on “continuity of interest” and the basic unfairness and economic harm of taxing a “paper gain.” To achieve full tax deferral, no gain is taken from a like-kind exchange; all the profit must be reinvested into a like-kind asset. The real estate investor remains invested in real estate at the end of the exchange. Likewise, the construction company remains invested in heavy equipment. Because of this, elimination of §1031 would result in a tax on cash flow, not a tax on profit.
1031 Applications from the Field
To see how 1031 impacts real estate agents and their clients in rural areas, we contacted real estate professionals Renee Harvey, ALC Advanced, with CENTURY 21 Harvey Properties in Paris, Texas and Ray L. Brownfield, ALC, AFM, 2012 President of REALTORS® Land Institute and Managing Broker/Owner of Land Pro LLC, in Oswego, Illinois.
Renee stated, “Our Company has represented clients that have been able to diversify their asset portfolio through 1031 tax deferred exchanges by exchanging one large parcel into multiple properties and increasing gross annual income. Other clients have exchanged multiple income producing properties in various locations and even different states into one property with almost equal gross annual income and significantly reduced maintenance and management costs”.
Ray’s experience is similar but he also points out the potential negative impact the elimination (or limitation) of section 1031 could have to the family farm. Ray stated, “Over the past ten years I have worked with many clients who have benefited from 1031 tax deferred exchanges. I live and perform real estate brokerage work in the “collar counties” area of Chicago, as well as the upper one half of Illinois. During the real estate development boom of the mid 2000’s, developers were offering to purchase land from local farmers at $30,000 to $75,000 per acre. Without section 1031, the sale of land (originally purchased at $500 to $3,000 per acre) would have created a tremendous tax burden to the owners, making it very difficult to invest in more land to continue their farming business. Through the use of section 1031 my clients were able to defer tax liability and I was able to locate and negotiate the purchase of replacement farmland in downstate Illinois at a price of about $4,000 to $5,000 per acre. This enabled my clients to continue farming or to retire and rent the land to neighboring farmers in the area. These individuals generally have a love for the land and always want to be farm land owners, passing it on to their children and grandchildren, if possible”.
“I probably did five to six of these types of transactions per year through 2008, when the development market slowed down during the recession. Recently with land values reaching new highs in downstate Illinois (around $10,000 to $14,000 per acre) some of these clients have had me sell a portion of their farmland to do a 1031 exchange again for land near their original land in Northern Illinois, which has dropped in value to $8,000 to $10,000 per acre as a result of the recession. Without 1031 exchanges this would not have been possible”.
“In my opinion if section 1031 is eliminated or limited, baby boomers who have inherited farmland with their brothers and sisters (not interested in farming or owning farmland) may be forced to sell. Because of the tax liability they could not afford to buy land to continue their farming activity. This would have a detrimental impact on long term family owned farmland”.
Both Renee and Ray point out the importance that section 1031 has to the American economy, the efficient use of land and ordinary citizens who live on Main Street USA. It is very unlikely that any of the farmers that Ray mentioned would describe themselves as being wealthy. More likely they would describe themselves as being hard working farmers or farmland owners trying to earn a living. Farmland is the “equipment” used by them in their businesses to support themselves and their families. Without 1031 exchanges, they would pay taxes on “paper gain” causing them to buy less land and accordingly suffering a reduction in their income.
What Can We Do About It?
Ask us for more information. Contact the REALTORS® Land Institute at rli@realtors.org. The Government Affairs Committee is very involved with this issue. Join the REALTORS® Land Institute to help have a voice on this issue.
Contact your Congressman or Congresswoman. Tell your Representatives how §1031 benefits your business or your clients. You can send a letter to your U.S. Senators and U.S. Representative through the IPX1031® website www.ipx1031.com. A sample letter that you can customize is already there, waiting for you.
Through these actions, you can make a difference!
This article was originally published in LAND Magazine, a Lands of America print publication. Subscribe here today!