Tax reform threatens IRC Section 1031
Tax reform in 2017 may eliminate the Internal Revenue Code Section 1031 like-kind exchange, according to Senior Republican law makers. Section 1031 has been a vital economic stimulant and part of the tax code since 1921. A study of the early tax court cases clearly shows that the two key purposes for the provision were (1) to avoid unfair taxation of ongoing investments in property and (2) to encourage active reinvestment1. The use and dependence on §1031 exchanges have grown over the past nearly 100 years to be a major underpinning of today’s national economy.
Farmers and ranchers in the agriculture community have the broadest use of §1031 like-kind exchanges to combine acreage, acquire high grade land, exchange breeding stock and upgrade farm machinery2. In addition to hard working farmers and ranchers, §1031 like-kind exchanges are used by individuals of modest means and small businesses. According to Cornerstone Real Estate Investment Services, a leading replacement property brokerage, in over half a billion dollars in exchange transactions over a period of a 14-year period, its average §1031 exchange transaction was a modest $288 thousand. Furthermore, the National Association of REALTORS® reports that 40% of all realtors state that without §1031 exchange many of their residential rental property transactions would not have occurred; some 63% of all realtors have participated in a §1031 exchange.
A major component of the Blueprint to achieve job growth and economic stimulus is a provision to allow for the immediate 100% expensing of all business investments. As defined by the Blueprint, business investments would include both investments in tangible property (such as equipment and buildings) and intangible assets (such as intellectual property). However, the immediate expensing will not apply to land. In addition, to discourage the use of leverage to acquire property purely for the tax benefit of immediate expensing, the Blueprint will take away the deductibility of the business interest expense—making mortgage interest expense non-deductible for real estate investments.
According to the Blueprint, the immediate expensing deduction could be netted against other capital gains and passive income in the year of the acquisition. Several members of Congress have commented to Cornerstone that they understand the intent of the Blueprint is to also allow the immediate expensing deduction to also be applied to ordinary (earned) income, and that the passive loss rules created by the Reagan Tax Reform Act of 1986 would not apply. Any remaining loss generated by the deduction could not be carried back but would be carried forward indefinitely.
Taken by itself, immediate expensing appears to be an amazing tax shelter allowing a taxpayer to shelter multiple year’s income (even ordinary income) from federal tax following a large investment property acquisition. Per the Tax Foundation, immediate expensing will cost the federal budget over $2.2 trillion over a ten-year period. However, if the taxpayer is selling an investment property with the intent to continue his or her investment in real estate in the form of a replacement property, there could be a potentially significant tax exposure under an immediate expensing regime that has not been present under §1031.
The Threat to Section 1031
The authors of the Blueprint have commented that that given the Blueprint’s lower capital gain tax rates and the provision for immediate expensing they don’t think that §1031 would be necessary.
If §1031 exchanges were eliminated during the tax reform process, a taxpayer would need to recognize the gain attributable to both the land and improvement component of the real estate when sold. Accordingly, it would be necessary for the sales price to be allocated between the land and improvements in the sales contract. The pure capital gain on the transaction for both the land and improvements would be taxed at the lower capital gain rates set forth in the Blueprint (most transactions being taxed at either the 12.5% or 16.5 percent rate), and any allowed or allowable deprecation of the improvements would need to be recaptured at ordinary income tax rates (most at 25% and 33%). In addition, there may be state taxes on the gain if the property were situated in an income tax state. These taxes would conceivably be payable as a tax withholding at the time of sale, as an estimated tax payment in the quarter the sale occurred, or by the due date of the seller’s tax return.
A Possible Solution
In the author’s opinion, the best solution may be found in President Trump’s campaign tax plan. The President’s plan would allow immediate expensing to manufacturers and allow real estate to continue to prosper as it has for nearly 100 years under §1031. This could be accomplished with a simple line item in the new tax legislation that exempts section 1250 property from the immediate expensing rules (1250 property includes real estate and real property subject to depreciation that is, and has not been, section 1245 property used in a business). This approach would also accomplish many of the goals set forth in the House Blueprint.
Section 1031 promotes savings and investment. Think about how much of America’s savings is in land alone, not to mention the improvements. The Federal Reserve’s Flow of Funds report contains enough data to calculate the value of privately held land in the U.S. at $14.488 trillion3. If immediate expensing replaces §1031, all this savings would be punished by being taxed. In most cases, land savings are ultimately exchanged using §1031 into income-producing property to fund retirement as the land owner ages. These savings are therefore indispensable to fund a large segment of the population’s retirement especially given the challenges to funding Social Security. Tax reform that would tax land previously un-taxed under §1031, land that comprises much of the savings for farmers and ranchers, would seem to be at odds with the Blueprint’s purpose of a fairer tax code.
Generate Economic Growth
Section 4 of the Blueprint focuses on economic growth, and immediate expensing would be a key tool in accomplishing that grown through tax reform. While there are as yet no studies on the economic growth that immediate expensing would provide, it should be noted that the Tax Foundation in 2016 reported that GDP growth would shrink by $18 billion dollars each year if §1031 like-kind exchanges were repealed. An earlier study by Ernst and Young reported a $13 billion yearly GDP contraction if §1031 were repealed.
A key component to the economic vibrancy and growth that §1031 like-kind exchanges provide for the economy is the turn-over effect. As there are currently no tax consequences under §1031 to selling an investment property and replacing it with a like-kind property of equal or greater value, there is no tax friction that discourages the turnover of investment property. Consequently, properties change hands at a greater rate. The new buyers often improve the property and “make it their own” by painting, improving, buying furniture and other fixtures, all of which benefit local industries such as real estate agencies, contractors, title insurers, lenders, equipment dealers, manufacturers, transportation, energy, and agriculture. In addition, city budgets and local schools also benefit from the turnover of real estate through new property value assessments. Immediate expensing, on the contrary, would discourage turnover and produce a lock-in or buy-and-hold culture, as a sale would generate significant taxes from capital gain, depreciation recapture, and state taxes.
Finally, it should be noted that §1031 is not a tax exclusion but a tax deferral. While there is a temporary deferral of capital gains which are taxed at lower rates, the rental income from the replacement property is taxed each year at higher ordinary income tax rates. Per a study by Ling and Petrova4, 88% of the real estate replacement properties acquired in a §1031 exchange are ultimately disposed of through a taxable sale, so eventually the tax does get paid.
A broad coalition of industry associations and organizations is engaged in efforts to alert lawmakers that §1031 needs to remains in the tax code. At this time the 100 plus member coalition includes the Federation of Exchange Accommodators (FEA), the REALTORS® Land Institute, the National Association of REALTORS®, and the Alternative Direct Investment Securities Association (ADISA) among others. Like-kind exchanges should be integral and complementary to tax reform, as §1031 exchanges promote economic growth, generate jobs, and benefit multiple industries, all while reducing taxes and the burden of tax compliance. Please make your voice heard by sending a letter to your federal legislators, to let them know how critical §1031 is to you and to your business at www.1031taxreform.com/take-action/.
John Harvey is president and owner of Cornerstone Real Estate Investment Services. ν
Harvey holds a Master of Business Taxation and a Bachelor of Science in Accounting from the University of Southern California Leventhal School of Accounting. Harvey has been a licensed CPA since 1991, and has worked as a Senior Manager with Deloitte & Touché in Los Angeles. Harvey is an Elite Adviser for Cornerstone, assisting investors in the purchase of over $500 million in tenants-in-common and Delaware Statutory Trust real estate. He is an affiliate member of the Federation of Exchange Accommodators (FEA) and a member of the Alternative Direct Investment Securities Association (ADISA).