The current election cycle generated a high volume of articles about the virtues or vices of real estate investment. (Exactly which depends on your political leanings.) Unfortunately, the pundits’ understanding of the tax laws has proven lacking. Perhaps the most prevalent misconceptions surround the like-kind exchange rules found in § 1031 of the Internal Revenue Code. That provision allows taxpayers to defer paying certain taxes when they exchange a business or investment property for a similar property of greater or equal value rather than selling for cash. While the majority of the recent commentary focuses on real estate, especially in light of Donald Trump’s businesses, individuals and companies use § 1031 in many legitimate industries. Repealing these provisions would not only fail to generate additional tax dollars for the government but would also stifle domestic economic growth. Today’s column seeks to clarify some of the misconceptions perpetuated by these articles.
Myth: § 1031 Exchanges Allow Taxpayers to Permanently Avoid Real Estate Taxes
Section 1031 provides a mechanism to defer tax, not to evade or avoid tax liability. It doesn’t even reduce the amount to ultimately be paid. Like-kind exchanges affect only the timing of when real estate investors pay certain taxes.
To completely defer the payment of certain taxes at the time she sells a property, § 1031 requires that a taxpayer jump through a series of hoops, including
1. not taking any cash proceeds whatsoever,
2. purchasing replacement property of greater or equal value,
3. acquiring all replacement property shortly after the first property transfers,
4. ensuring the owner of the new property is the exact same taxpayer as the selling party (i.e., not creating a new company or buying out investment partners),
5. acquiring replacement property that is “like kind” to the relinquished property, and
6. holding the replacement property for investment or business use rather than personal use. If the property owner fails to follow any one of these requirements, the taxpayer pay tax on the transaction for the year the investor sells or transfers the original property.
Further, even if all of the necessary steps are followed, the deferral of taxes is only temporary; an overwhelming 88 percent of properties acquired through like-kind exchanges are later disposed of through fully taxable sales. (See The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges In Real Estate, David C. Ling & Milena Petrova, Marc & June 2015, p. 54.) And when the sale actually occurs, the tax bill will apply to a more expensive replacement property because the § 1031 rules require the new property to be of greater or equal value than the original property [see above].
Myth: § 1031 Is Bad for the U.S. Economy
While it may seem counterintuitive, § 1031 exchanges actually encourage investment, create jobs and stimulate the economy. One reason is the rule that replacement property is of greater or equal value, as discussed above. So businesses and investors are actually “trading up” and investing in more (or more expensive) property than they started with. The tax deferral also encourages people to sell instead of holding their assets and to invest in capital improvements. Each sale consequently employs a variety of people (i.e., contractors, surveyors, environmental consultants, escrow officers, and public utility workers). These transactions stimulate the economy, in part, because it diverts capital gains tax revenue to productive use.
1031 exchanges play an integral role in many industries besides real estate. These include construction, truck and air transportation, equipment/vehicle rental and leasing, and oil and gas extraction and pipelines. They encourage transportation companies to upgrade their vehicles. They also encourage businesses to improve their systems and equipment. Research shows that elimination of § 1031 exchanges in these industries would reduce America’s annual GDP by $27.5 billion, according to the 2015 “Report on the Economic Impact of Repealing Like-Kind Exchange Rules,” from Ernst & Young LLP. Repeal of § 1031 would also lead to increased cost of capital, reduced levels of investments, slower economic growth, a concentrated burden in those industries that rely heavily on like-kind exchanges, and the long-term contraction in the overall U.S. GDP of approximately $8.1 billion annually, the same report estimates. §1031 keeps money here in America, as only U.S. property qualifies for an exchange.
Myth: § 1031 Exchanges Favor Developers
Contrary to recent reports in the New York Times, developers rarely use §1031 exchanges. A developer’s real estate is their inventory, not property held for investment. Further, §1031 exchanges can only capture the value of improvements made within 180 days after the sale of the taxpayer’s relinquished property. As significant real estate developments take substantially longer than six months to complete, §1031 does not provide a useful tax shelter for such projects.
Myth: § 1031 Only Favors the Wealthy
1031 is one of the few incentives available to, and used by, taxpayers of all sizes. Exchanges help individuals, partnerships, limited liability companies and corporations. In fact, 60% of exchanges involve properties worth less than $1 million. And more than one third sell for less than $500,000, according to the May 2014 report from the Federation of Exchange Accommodators, “Impact of IRC §1031 on the Economy.”